ASX A-REITs: What happened in the June quarter and what is coming?
The S&P/ASX 300 A-REIT Accumulation Index fell sharply, giving up 17.5% in the quarter ending 30 June 2022. The property index underperformed the broader equity market, which also gave up significant ground in the period. The S&P/ASX 300 Accumulation Index lost 12.2% in the quarter.
Interest rates were once again the driving force behind the poor market outcomes.
At the start of the quarter the yield on the Australian Government 10 Year Bond was 2.8%, and by the end of the period the yield was 3.7%. This doesn’t tell the full extent of volatility through the period, with the 10 Year yield almost hitting 4.2% at one point.
The most direct and instantaneous impact of this move for real estate investment trusts (REITs) is an increase in interest costs.
The vast majority of REITs have some form of (very manageable) debt, and almost all have a portion of that debt exposed to floating interest rates. The increase in rates is therefore a direct headwind to earnings. Even fixed rate debt needs to be periodically refinanced and refinancing rates will naturally be higher. Furthermore, the value of property is also negatively impacted as rates rise, as investors discount the future cash flows at a higher rate.
Many investors compare property capitalisation rates to government bond yields, with the difference between the two rates known as the ‘spread’. Given that government bonds have a lower risk profile than property, this spread is highly likely to be positive over time.
In an interesting twist, at current book valuations some properties now have a negative spread to government bonds. Listed property investors clearly don’t believe this is sustainable as shown by share price movements.
Property fund managers were the major underperformers for the quarter. Fund managers are particularly sensitive to property valuations, as base fee income is tied to assets under management and performance fee income is commonly tied to total returns. Adding to potential issues, should confidence in the sector wane, future inflows into funds may stall. Centuria Capital Group (CNI) led the decline falling by 35.2%, Charter Hall Group (CHC) gave up 33.1% and Goodman Group (GMG) lost 21.4%.
Residential property developers were also broadly underperformers for the period. As mainstream media points out ad nauseam, interest rates have a direct impact on housing affordability. Major banks are directly passing on increasing interest rates to consumers, with 5-year fixed rate home loans at Commonwealth Bank (CBA) now facing interest rates of 6.69%. Perth-based developer Peet Limited (PPC) lost 19.7% for the quarter and Mirvac Group (MGR) dropped by 18.6%.
Direct office market transactions continue to support strong valuations, however, future transactions will be of great interest, given recent news. Dexus (DXS) marginally outperformed, still giving up 16.6%. Elsewhere, GPT Group (GPT) was off 18.5% and Centuria Office REIT (COF) fell by 20.8%.
Retail landlords significantly outperformed in a relative sense, with solid consumer spending data, supportive of outcomes in the short term. For the quarter, Vicinity Centres (VCX), SCA Property Group (SCP), and Scentre Group (SCG) lost 1.6%, 3.1%, and 15.1% respectively.
February’s reporting season was broadly positive for property stocks. Investment property valuations moved higher, although the rate of change has most certainly slowed. Earnings were also solid across all subsectors and outlook statements remained robust.
The industrial sub-sector continues to be the most sought after, given the tailwinds of e-commerce growth, the potential onshoring of key manufacturing categories and the decision by many corporates to build some redundancy into supply chains to cope with current disruptions. All of these factors will support the ongoing demand for industrial space.
The jury is still out on exactly how tenants will use office space moving forward, albeit demand for good quality well located space remains robust, and transactional activity of office assets continues to provide ample evidence of value.
We remain cognisant of the structural changes occurring in the retail sector with the growing penetration of online sales and the greater importance of experiential offering inside malls. Recent events will likely accelerate these changes. It is also interesting to note the juxtaposition of very high retail sales figures despite very low levels of consumer confidence, no doubt impacted by rising costs of living.
The recent increase in bond yields does present a headwind for all financial assets, and particularly yield based sectors such as property.
However, with key large capitalisation REITs now trading at a significant discount to the value of their underlying assets, with no value ascribed to embedded active businesses, we believe the sector offers value, particularly in comparison to unlisted property.
Phoenix has for some time discussed the risk of inflation, given the enormous fiscal stimulus and extreme monetary policy setting that we now live with. In very recent times, commentators and bond markets have begun to react to the presence of such a risk. In this environment, long leases with fixed rent bumps, which were previously in high demand, may become relatively less attractive. Historically, real assets such as property and infrastructure have performed well during inflationary periods.
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Stuart Cartledge is the Managing Director of Phoenix Portfolios and the portfolio manager for each of the company’s property portfolios / funds. Prior to establishing the business in 2006, Stuart had built a very strong track record in the listed...