The Australian Real Estate Investment Trust sector’s total return of 13.2% for the 2018 financial year might get investors a little excited, especially with earnings growth of 3.4%1 over the period. Here we summarise the 3 key themes from reporting season and run through each of the main sub-sectors.
Three key takeaways from this reporting season
The most satisfying aspect was the way things are ticking along exactly as we hoped; improving fundamentals and lower risk - and no surprises.
1. Earnings and distributions are going up
AREIT earnings per share (EPS) increased 3.4% over FY18 with similar growth expected next year. While the extent of this growth was lower than last year, the consistency with next year’s forecast is a good sign. FY19 earnings were revised down by analysts, driven by retail AREITs (see below), but with inflation running at about 2%, EPS of 3.4% looks just fine.
2. Asset values are rising
Real estate values continue to rise across most commercial asset classes. Net tangible asset values (NTA) were up 9.7% across the sector over the year. The office sector, driven by strong capital appreciation along the eastern seaboard, was the best performing. Industrial assets values also performed well with logistics assets leading the charge.
3. Debt is coming down
Gearing (debt to gross asset values) was 25.9% across the sector, 1% lower than a year ago and, according to JPMorgan, the lowest since 1999. AREITs are well positioned to deal with higher interest rates, with average debt terms over 5.5 years. Reliance on bank debt – so detrimental during the GFC – has also been significantly reduced. AREIT investors may be unaware of such progress but it makes their investments appreciably safer.
A look at individual asset classes
Some retail centres hit harder than others
A stark variation in performance is beginning to emerge in the retail asset class. This won’t surprise long-term investors in APN’s AREIT Fund – we’ve long held a view that flagship centres will prosper while sub regional malls may suffer. Now the hard facts are emerging due to the current difficult trading conditions.
Low wages growth, declining house prices and rising household expenses (especially in utilities, mortgages and health expenses) aren’t conducive to heading to the mall to buy big ticket items. Sub-regional centres and high street retail are bearing the brunt of these headwinds. We don’t own High Street retail which is the worst affected.
The weaker performance of these assets was in contrast to flagship centres, which enjoyed good valuation growth. A number of transactions and revaluations occurred at record levels and these centres remain our favoured exposure.
Convenience/Neighbourhood retail was also a bright spot, along with CBD retail which is enjoying a resurgence, driven by tourism and higher inner-city densities. These centres continue to be well supported by shoppers and investors, as do catchment dominating regional centres in our biggest cities and towns.
While retail assets delivered mixed results the sector’s income growth closely matched inflation at 2.1% but was down on the 2.8% seen last year. It’s not a great environment for retail right now but some areas offer better protection than others.
While income growth slowed, shopping centre productivity (the amount of sales a centre gets per square metre of space) was a bright spot growing by 3.1% over the year. That’s a good indication that, as we suspected, Amazon isn’t having the impact on bricks and mortar the market thought it might a year or so back. Shopping centre occupancy rates were also stable at 99% indicating landlords aren’t seeing this impact either.
Convenience, differentiated products and compelling shopping experiences will keep the foot traffic coming. Reporting season has shown that retail assets lacking these attributes will struggle in this cyclically slow and evolving environment.
The office party continues
The music remains loud and thumping in the Sydney and Melbourne office markets, where vacancy rates are just 4.7% and 5.0% respectively. The result is predictable: extremely strong rent growth of almost 8% in these markets. Without the glut of supply usually associated with such conditions there’s every chance rental growth will continue.
It’s gratifying that the lessons from the ‘90’s office development boom haven’t been forgotten. What landlord could forget an oversupply hump causing >25% vacancy rates leading to rental declines of over 50%.
Income growth of 3.6% for the year was up from 1.4% in FY17. This more tempered growth occurs due to the term of an office lease. With an average lease expiry of five years, around 20% of AREIT office tenants renew their lease each year, the remainder having fixed annual increases. Sydney and Melbourne tenants are paying far higher market rents to remain in their buildings or a new tenant is signed up, providing extra fuel to normal fixed increases across 80% of an AREIT’s portfolio. The effect is to smooth out earnings growth, improve its sustainability and shelter investors from the volatility of the business cycle. Very nice.
Industrial a top performer
Industrial income growth and capital returns topped the AREIT sector this reporting season, although the results are skewed by logistics-focused Goodman. The company now has over half its assets offshore and excels at development and managing assets on behalf of investors – less than half of its earnings derive from rent nowadays. Were it listed anywhere other than Australia it wouldn’t be classified as a REIT at all.
Goodman is very good at what it does but in our view non-rental (corporate) earnings are higher risk than collecting rent, which is another reason why it won’t ever be a big part of our portfolio. Other smaller cap industrial names provide the yield and sustainable income we desire from assets which are all located in Australia. They are also benefiting from strong capital growth due to leasing success and strong buyer demand.
Other AREIT milestones
In May we waved goodbye to Westfield and the Lowy family’s 58 year involvement in Australian listed retail shopping centres. The impacts of the merger were immediate. On its last day of listing, Westfield Corporation (ASX:WFD) constituted 13.7% of the AREIT300 Index. On the first day of the Unibail CDI listing (ASX:URW), the equivalent figure had declined to 8.4%.
Currently APN has calculated URW as being around 5.4% of the index, the further decline mainly due to offshore holders of the former WFD switching into the European-listed Unbail. We have previously extolled the virtues of Unibail and its long-term track record. At a current distribution yield of 6.5%pa3, it’s a compelling investment opportunity.
From a new opportunity to one that is about to conclude. Investa Office Fund (ASX:IOF) is the gift that is finally giving.
Blackstone made an initial $5.15 offer for IOF on 25 May this year, which we recommended investors reject. In our view the stock was worth a lot more. Updated valuations received in late June resulted in its NTA increasing from $4.95 to $5.48, the key premise of our position. All we needed was a higher offer from Blackstone.
That finally arrived after a shrewd move by Investa management, who introduced Oxford Properties to the bidding table. This has coerced two higher bids from Blackstone, the last being $5.52, with a counter from Oxford at $5.60. As we said in June, “In our view, a figure of at least $5.60 per share would be more reasonable.”
Well, we’re getting close. With offer pricing now above NTA our investors are getting appropriate compensation for losing the last specialised office AREIT. But a few more cents are always appreciated. Who doesn’t like to be right on the money?
In conclusion, the AREIT sector remains in good shape with a solid earnings outlook. Providing investors with secure income and managing risk remains the key focus for AREIT management teams. This is the main attraction of the sector. We look forward to a boring 2019.