An opportunity in A-REITs

An emerging risk of 2023 is the potential for heavy losses in commercial real estate. Higher interest rates are pressuring interest coverage ratios and are placing downward pressure on asset valuations, a key ingredient in important solvency measures such as gearing.

Issuers with the most debt within their capital structures are most exposed. Some highly leveraged structures that could be maintained during the prior era of ‘lower for longer’ interest rates are now no longer fit for purpose.

In considering which issuers and regions are most exposed to these pressures, one measure we can evaluate is debt to enterprise value. This includes the current value the equity market is placing on commercial property portfolios in the context of current interest rate settings – not book values which may be slower to react.

This allows us to compare how select listed REITs from Australia, the US and Europe stack up.

European real estate trusts are most at risk from financial distress. As the below chart shows, their balance sheet settings are the most aggressively positioned with many REITs having prioritised building scale of assets under ownership over more modest financial policy settings in years past.

However, those capital structures now need to be ‘rightsized’ for the new environment. Asset sales, equity raisings and in some cases restructurings and defaults will occur. Adler, shown in the far left, recently had a restructuring plan approved to facilitate an orderly wind-down of the business – an action S&P considers as tantamount to a default.

For listed Australian real estate trusts the outlook is relatively sanguine. The more conservative financial policy settings after the sector blew up during the Global Financial Crisis sees issuers less exposed. Lower gearing in combination with well spread funding profiles should result in refinancing pressures that are lower in aggregate than in Europe. This also means that mitigating actions such as asset sales and equity raising – while very likely to play a part – should also be less prevalent in Australia.

REIT sector sentiment in Europe is impacting all EUR-denominated credit, including in A-REIT paper issued.

Scentre, Vicinity and Stockland’s EUR bonds provide significantly more value than their AUD lines and offer up to 0.6% more yield per annum.