AREIT reporting season: 8 key takeaways

Many AREIT investors fear the impact of higher interest rates. Results from the latest reporting season should allay those fears. AREIT pricing already accounts for that prospect, although in many cases private asset values do not.

The gap matters. For the Dexus AREIT Fund, the discrepancy between price and value helps us to purchase at attractive prices high-quality assets with growing rents and sensible balance sheets. Several AREITs concur; they are making the same judgement and buying back their own securities.

In March, I wrote that the “sector is enjoying improving fundamentals and strengthening capital markets but the disconnect between listed valuations and private market pricing is accelerating.” That disconnect continues, as does the opportunity.

Here are our eight key takeaways:

Scarcity is now beginning to bite. New buildings are expensive to deliver while the required return to justify development has risen. For a growing number of landlords, a development now needs to produce a yield of at least 7% to justify the investment. This is a much higher hurdle than even a few months ago.

Fewer and fewer projects jump it. Supply is constrained, improving the outlook for owners of existing assets. Land bought cheaply years ago can still make some projects work, but the advantage increasingly sits with landlords who do not need to build their way to growth. This is the focus of the Dexus AREIT Fund, currently featuring a running yield of ~6.5%.

For many AREITs, income is now the main growth engine. Inflation-linked reviews are increasing rents and tenants are generally finding such increases manageable. Among industrial properties, many leases remain below current market rents. Landlords have room to increase income without upsetting tenants. Rental growth is a simpler and, in our view, more durable source of value creation than asset value.

While debt has become more expensive, AREITs' access to it remains strong. Good borrowers with debt levels at or near historical lows are not being shut out. This works in the sector’s favour. As the big four cut back on their exposure to data centres, large AREITs with strong asset bases can choose between competing sources of finance. As for leveraged private borrowers, they’re finding conditions much tougher.

Given the value on offer, as mentioned above, it shouldn’t surprise that more AREITs are buying back their own securities. When a trust trades below the value of its underlying property, buying that portfolio on market can be more attractive than acquiring another building or starting a new development.

That boards with detailed knowledge of their portfolios are choosing to buy their own assets at today’s prices, beyond other uses of capital, is a good sign for AREIT investors. We have long believed many AREITs are undervalued; such support our thesis.

The market is becoming less forgiving of average properties. In both office and industrial, the gap between the best assets and everything else is widening. Tenants are prepared to pay for efficient, well-located buildings while secondary stock is taking longer to lease and often needs larger incentives. This is a healthy dynamic, creating more opportunity for active investors.

Retail produced the strongest operating results of the major commercial sectors. Shopping centres are close to full, arrears are low and retailers are still looking to lease more space. After a softer June, July and August sales improved while rents remain affordable relative to tenant sales. This gives landlords room to push rents further. Investor demand has followed operating performance, in convenience, neighbourhood retail and the destinational malls.

Residential demand remains sound but buyers are increasingly price sensitive. Affordable lots and homes are selling faster than higher-priced land and properties. Western Australia and South-East Queensland remain the strongest markets while Victoria is the weakest. Listed developers also have an advantage as finance is easier to obtain than it is for smaller competitors.

The pressure is showing where debt and operating risk combine. Private-equity-backed operators in healthcare, childcare and retail are dealing with higher interest costs while some segments of private credit are fighting thin development margins.

Data centres offer a different risk: capital requirements are rising while approvals and power connections are difficult. Banks have started limiting their exposure. None of this amounts to broad property stress, but it does reinforce the value of conservative financing and thoughtful choices in asset selection.

Reporting season by sector

Office is improving, although headline vacancy rates simplify a complex market. Premium CBD space in Sydney and Brisbane is attracting tenants, and incentives in these cities are easing. Technology companies are a source of new tenancies, especially in higher-quality buildings. Melbourne remains soft, although the strongest assets are performing well.

The better opportunities are no longer simply “office”; they are specific buildings bought at prices that compensate for the remaining leasing and capital expenditure risk. There are opportunities, but they are very specific in their financial metrics, tenant appeal and geographic location.

The strength of the retail sector continues to surprise. Centres are full, tenant retention is high and landlords are being more selective about who gets space. Food and beverage, supermarkets, health and wellness, jewellery and leisure retailers are strong, while luxury, homewares and some electronics retailers are softer. Now that borrowing costs are higher, the easy valuation gains may be behind us, although rental growth remains strong enough to support ongoing attractive returns.

Industrial has returned to a more normal base level. Leasing incentives are rising and rental growth has slowed but good assets can still achieve positive rent increases when leases reset. Demand is increasingly selective, with modern buildings benefiting from automation requirements and data-centre-related activity. Secondary assets and weaker locations are more exposed as the extraordinary shortage of recent years fades.

Sales slowed through the financial year to June but remain high by historical standards. Defaults remain low. Developers are responding by reducing lot sizes and concentrating on delivering affordable products. Western Australia and South-East Queensland continue to benefit from population growth and limited supply. Again, Victoria is weak but relative affordability gives it more recovery potential.

Land lease, combining affordable housing with recurring, inflation-linked site income, was strong while Childcare was more mixed. Occupancy has slipped and regulation is adding costs, although fewer new centres should help established operators and landlords.

Self-storage is weakening as housing turnover slows. Data centres still offer substantial long-term demand but the path from an attractive narrative to acceptable returns is becoming fraught. Capital and power constraints, plus planning logjams, make this a challenging sector for developers and investors.

Final thoughts

This reporting season, the clearest divide was between owners of scarce, existing assets and businesses that must build, borrow or raise fresh capital to create a return. Higher costs are rationing new supply as population growth boosts demand.

That is a favourable setup for the Dexus AREIT Fund. We can buy established assets with growing income through listed vehicles that, in many cases, trade below the value of the property they own.

We do not need interest rates to fall sharply for our portfolio positions to work out. We need rents to keep growing, balance sheets to remain sensible and management teams to sensibly allocate capital well. This reporting season offered more evidence of all three.