If cash is king, then rent is an ambitious prince for listed property investors. It’s all (mostly) about rental income for those sifting real estate investment trusts and the offices, warehouses and shopping malls in which they invest. 

In the prior two articles in this collection, we’ve looked at the most important ways our three contributors gauge the quality of assets, including tenants’ capacity to keep the rent paid and debt collectors at bay. Alongside free cash flow and yield, structural aspects (long-term themes that determine the likelihood of success or otherwise) are high on the list. Accelerating online adoption is one that stood out for me as surprising in such a bricks-and-mortar context. But it’s largely why both retail and offices will struggle (think e-commerce and work-from-home) in the medium-term.

In part two, our contributors outlined where they're most bullish for the next few years. Pengana Capital's Amy Pham and Trilogy’s Philip Ryan each gave five reasons for the appeal of A-REITs more broadly and residential property specifically, respectively. And Freehold’s Grant Mackenzie named three Quality REIT securities in his portfolio, including a surprising retail-exposed pick.

In the final part of the series below, industrial is the jewel in the listed property crown for all three. In the following wire, our trio discusses why the COVID recovery is a particular boon for their favoured sector, as are macro trends in currency, interest rates and supply-demand dynamics. They also outline some individual securities and assets on their books.

“As good as it gets”

Amy Pham, portfolio manager, Pengana

Despite bond yields having risen sharply over the month, they remain at historically low levels. We believe this is as good as it gets for REITs, with cap rate compression doing most of the heavy lifting over the past five years.

Looking forward, we are supportive of REITs that have strong balance sheets to drive earnings growth, and which are in sectors with positive thematics or secular trends. Both Goodman Group (ASX: GMG) and Charter Hall (ASX: CHC) fit these criteria. 

They have the strongest balance sheets in the sector with less than 5% gearing and capacity of more than $2.8 billion and $6 billion respectively. They both have strong development pipelines with structural tailwinds driving future demand.

For GMG this is reflected in its work-in-progress of $8.4 billion, nearly double that of the corresponding period last year, and projected production rate of $5 billion a year, generating strong margins that will support earnings growth over the medium term.

CHC has demonstrated an ability to grow FUM at 30% a year and has high recurring fees (no performance fees included in the guidance). The team also runs a diversified portfolio with a long weighted average lease expiry of more than nine years and is well-placed to grow in the alternatives sector and participate in “sale and leaseback” transactions.

On the flip side, we see continued earnings pressure for large retail REITs Scentre Group (ASX: SCG) and Vicinity Centres (ASX: VCX). Reasons for this view include:

• poor operating matrices (significant negative leasing spread of -12 to -15%,
• sales MAT (moving annual turnover) of -18%
• low earnings visibility.

For these companies, the continued structural shift to online retailing is also putting pressure on valuations.

Across this category, there is continued concern about the amount of CAPEX needed to reconfigure assets. This is reflected in brands David Jones, Target, Myer (ASX: MYR), Kmart and others closing stores over time and the absence of large offshore retailers coming to fill this space. Recently, Myer flagged an additional near-term reduction of around 70,000 square metres (sqm) in its floorspace requirements. And in recent years both Vicinity’s and Scentre Group’s main developments have been in mixed-use projects such as hotels, residential and office, which indicates that the return on capital is not there for retail.

The power of the Aussie dollar

Philip Ryan, co-founder and managing director, Trilogy Funds Australia

Industrial property is a standout area for us, where we see competitive income returns, diversification, long-term capital growth and acceptable levels of risk. This contrasts with the office segment – particularly for small-to-medium businesses, where we believe the vacancy rate in CBDs especially will be higher than originally forecast last year. Similarly, we have concerns for retail, specifically city shops where there are high degrees of vacancies. These vacancies have been driven by physical restrictions implemented during COVID-19 lockdowns, and the resulting sharp-increase in e-commerce. I believe retail’s prospects will improve once people return to the city, though that could be some way off.

But in industrial property, we’re seeing the combined benefit of the low Australian dollar, high commodity prices and exposure to the booming logistics sector. Tenants in the mining and manufacturing sectors, particularly exporters, are also benefiting from high commodity prices and a reasonably low local currency relative to the US dollar. 

The investment case for industrial is being driven by high demand but modest supply.

We hold seven properties in the portfolio – six in Queensland, and one in South Australia. All with five-year leases and most having footprints of around 15,000sqm, they include:

• An industrial and office property on Queensland’s Gold Coast, leased to Mineral Technology, a subsidiary of ASX100 company Downer EDI
• A Brisbane industrial area-based property tenanted by Stoddart Group, a supplier building materials and solar power products
• A Mackay, north Queensland site leased to earthmoving and mining equipment supplier Komatsu.

What's priced-in, and what's outpriced

Grant Mackenzie, senior portfolio manager, Freehold Investment Management

This is about the relative value, that is, what’s priced in and what’s not. Look at the Office sector, which is currently trading at 20-25% discount to NTA – is that warranted or overshot? In our view the latter. 

While we acknowledge that effective rents will come back and vacancies will lift, exacerbated in second-tier assets as tenants move into higher-quality assets, we still think firms want their staff back in the office for productivity, collaboration and cultural reasons. Office is not dead!

Similarly, Retail malls are also trading at a big discount to net tangible assets but in contrast to the Office sector, the NTAs are not validated by transactional evidence. Malls still have increasing vacancies and they are struggling to backfill the spaces available. To overcome these vacancies, malls have had to diversify into different asset classes – more service-related, such as gyms and childcare. This is new, and being done to solve the vacancy issue but the rents are lower. Overall, the sector stills need to adapt to the structural challenges present - that shopping habits have changed – something that was accelerated due to Covid-19.

We don’t believe the market is fully appreciating the challenges, nor the fact that malls will not revert to ‘normal’ due to the substantial changes in shopping habits. For these reasons, Freehold is still cautious towards the sector and remains underweight in large malls.

A key to the cure

As the vaccine-led recovery continues to roll out, the raw materials needed to keep kickstarted manufacturing companies supplied will be crucial, and these logistics and warehousing requirements are reflected in the industrial property theme emphasised throughout this three-part series. Another industrial segment briefly touched on was data centres, a theme that’s quickly catching on for investors as the digital revolution got its own shot in the arm throughout COVID and beyond. 

What becomes of the office and shopping mall remains an open question, but the near-universal view is one of transformation and adaptation rather than extinction.

Catch the rest of this series

Make sure you "FOLLOW" my profile read the earlier entries in this series. In part one, the contributors explained how their stock pickers were sifting the winners and losers in listed property. And in part two, our trio revealed 10 reasons and 3 stocks to back Australian listed property.