AREIT investors take stock as interest rates start to climb

Amy Pham

Pengana Capital Group

This month, Australia’s two largest economies started reopening after months of lockdown, with expectations that it could unleash a wave of consumer spending and people returning to the office.

Will things be back to normal or has the pandemic created structural shifts that the ‘new normal’ is here to stay?

Meanwhile, the backdrop has also changed. With interest rates heading back toward where they were at the beginning of the year and concerns around cost inflation, reduced stimulus, and labour shortages threatening to muddy the outlook.

With the market expecting interest rates to rise from these historically low levels, we assess below the impact this would have on AREIT’s earnings and the flow-on effect on the cost of capital and valuation.

From an earnings perspective, at first glance one can say that the impact of higher interest rates has minimal impact as the average gearing level for the sector is relatively low at 27%.

However, with fierce competition for quality assets, many REITs (particularly the externally managed REITs) have utilised low floating rate debt to maximise the earnings accretion from acquisitions.

As a result, REITs’ earnings are now much more exposed to interest rate moves, with more than 35% currently unhedged compared to 20% in the previous year.

 As an example, Scentre Group (SCG) has annual rent escalations of CPI +2-3% p.a. on a majority of leases. However, with leverage of >40% and historically low hedging levels of 55%, we see headwinds to earnings if interest rates continue to rise.

Currently, the average debt cost for the AREIT sector is 3%, compared to 4% three years ago. The expected rise in rates would make it harder for externally managed REITs to grow through debt-funded acquisitions.

The flow-on impact would be a slowing of fund manager’s AUM growth, and more importantly, it will highlight the REITs that are able to grow earnings through capital recycling and development compared to those purely relying on acquisitions.

On valuation, the AREIT sector has, for the past 10 years, benefited from falling interest rates supporting cap rate compressions.

Going forward, as rates start to rise, we see a slowing in cap rate compressions and a catch-up in rental growth, particularly for favourable asset classes such as logistics. Our valuations assume a 3.5% bond rate which is 1% higher than the market.

This provides us with a buffer in the event of further rate rises. The average forecast distribution yield of the sector is currently 4%, providing a 195 basis point yield gap to 10-year bonds that should continue to provide support for the AREIT sector.

So how are we positioned?

We remain positive on the outlook for fund managers (Charter Hall Group (CHC) and Centuria Group (CNI)) and residential developers (Cedar Woods (CWP) and Peet Ltd (PPC)), particularly inland sub-division.

We continue to increase our exposure to the alternative sector with our recent take-up of the newly listed RAM Essential Services Property Fund (REP), taking our total exposure to the alternative sector to 25%.

Learn more

More information about Amy's fund can be found here. Stay up to date with the latest high conviction opportunities in the property sector by registering for Amy's next webinar here, or contact us to learn more about the Pengana High Conviction Property Securities Fund.

Pengana Capital Ltd (ABN 30 103 800 568, Australian financial services license number 226566) is the issuer of units in the Pengana High Conviction Property Securities Fund (ARSN 639 011 180) (the “Fund”). A product disclosure statement for the Fund is available and can be obtained from our distribution team. A person should obtain a copy of the product disclosure statement and should consider the product disclosure statement carefully before deciding whether to acquire, or to continue to hold, or making any other decision in respect of, the units in the Fund. This report was prepared by Pengana Capital Ltd and does not contain any investment recommendation or investment advice. This report has been prepared without taking account of any person’s objectives, financial situation or needs. Therefore, before acting on any information contained within this report a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs. Neither Pengana Capital Ltd nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in, the Fund.

Amy Pham
Fund Manager - Pengana High Conviction Property Securities Fund
Pengana Capital Group

Amy is portfolio manager of the Pengana High Conviction Property Securities Fund, and has over 20 years of property funds management experience. Previously, Amy has worked at Charter Hall/Folkestone for 6 years, managing a high conviction...

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