Why more A-REITs are paying better, more reliable yields

Photo of Andrew Wilkinson By Andrew Wilkinson

min read

Understanding listed property distributions and tax outcomes.

The underlying investment characteristics of Australian Real Estate Investment Trusts (A-REITs) are somewhat different to other parts of the Australian listed investment universe. Understanding the differing characteristics of each A-REIT is key to determining how they generate their investment returns, the risks that may affect those returns and how they deliver returns to their security holders.

A-REITs, previously called property trusts, are listed on the Australian Securities Exchange (ASX). They own a range of different types of commercial or residential property and include the more traditional sectors of offices, retail shopping centres and industrial property in Australia and overseas.

Increasingly, property portfolios that have historically been privately owned, such as healthcare facilities, pub properties, childcare centres, self-storage facilities, data centres and rural properties, are listing on ASX.

There are about 40 A-REITs listed on ASX and those included in the index have a total market capitalisation of around $110 billion. The largest is Scentre Group, which owns a number of Australian-based Westfield shopping centres with a market capitalisation of around $24 billion.

To put the scale of the A-REIT market in context, the market capitalisation of the listed US and UK-based REITs included in the indexes are around $930 billion and $85 billion respectively.

A-REITs are favoured by investors for their relative financial stability and reliability of distributions to investors. They also tend to pay higher yields compared to the broader market.

(Editor’s note: Do not read the following ideas as stock or sector recommendations. Do further research of your own or talk to a licensed financial adviser before acting on the themes in this story).

Why A-REIT yields are generally more reliable

A-REITs typically own properties with tenants who are committed to paying rent on long-term leases. As a result, their income becomes highly predictable, with variations to cash flow driven by factors that are usually not highly volatile, such as vacancy rates, changes to the value of incentives required to fill tenancies, and the costs of outgoings, including insurance, land tax and property maintenance.

Some properties have the less common but very valuable “triple net” type of long-term lease. In this case, the tenant, rather than the landlord, is responsible for a range of property outgoings. These leases enable A-REITs holding such properties to provide very reliable earnings and distribution guidance to their investors because the underlying income and expenses are highly predictable.

This is particularly so where the underlying properties are leased to tenants with an investment-grade credit standing, such as large national companies or departments of federal and state governments.
Why A-REITs pay higher yields than many other investments

A-REITs own their properties through a unit trust rather than a company. Most trusts distribute a larger amount of their earnings because they are required to periodically distribute an amount equal to at least that year’s entire taxable income, otherwise the trust will pay tax. By paying a taxable distribution, the trust does not pay tax; instead, an investing unitholder will include the distribution in their taxable income.

Many A-REITs pay more than 100 per cent of the trust’s taxable income as their cash flow often exceeds the taxable income, because of the effect of tax deductions such as depreciation and building allowances. Accordingly, some A-REITs may pay out a larger proportion of their cash earnings, which will exceed their taxable income.

Finally, A-REITs may sometimes distribute an amount that exceeds both their periodic taxable income and cash earnings. This will usually occur when the A-REIT’s gearing is below its target level or there is surplus capital resulting from property sales or significant revaluations. On those occasions it may be prudent for a capital distribution or a return of capital to be made to investors.

Understanding ‘tax deferred’ distributions

In the most simple scenarios, when an A-REIT distributes more than its taxable income the balance will usually be classified as a “tax deferred” distribution. In essence, the value of the distribution is deducted from the initial capital value of the investment, rather than being included in the investor’s taxable income.

As a result, the tax on this part of the distribution may be deferred until either the investor sells the securities, sometimes many years after the distribution has been received, or the ‘tax deferred’ distributions reduce the investor’s tax base in the investment to nil. In these cases the capital gain may be subject to concessional taxation treatment for the investor.

The taxation of trust distributions becomes less straightforward when an A-REIT’s distributable income is generated from property sale gains or losses, or from income relating to properties overseas.

Outlook for A-REIT earnings and distributions

Many A-REITs have worked successfully in recent years to increase the quality of their properties, focus more on domestic property acquisitions, decrease costs by bringing property management in-house, and constructed their balance sheets to better manage the cycles of the property and debt capital markets.

Many have also moved to fix an increasing proportion of their interest expenses at what are currently low rates at both the short and longer ends of the curve. These A-REITs are well positioned to continue to deliver predictable and growing earnings and distributions for their investors.

About the author

Andrew Wilkinson is Managing Director of ALE Property Group @ALE_Property, the owner of Australia’s largest portfolio of freehold pub properties. It was established in 2003 and owns 86 pub properties, across the five mainland states, currently valued at around $950 million. ALE is listed on ASX.

From ASX

A-REITs has information the features, benefits and risks of investing in Australian Real Estate Investment Trusts and links to sector data.

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