Is there a future for retail and office A-REITs?

Offices are going extinct. Shopping malls are going to become ghost towns. These are some of the theories being bandied about by investors looking to the other side of the COVID-19 crisis. But will they hold true?

For years Australian Real Estate Investment Trust (A-REIT) operators have based their business models on thematics previously considered undisruptable: employers leasing out corporate headquarters to provide a dedicated workplace for staff, and consumers undertaking retail therapy at their local Westfield.

The Black Swan brought about by the pandemic is raising questions over these business models and the end returns for investors. Companies led by Optus, for example, are making coronavirus-era work-from-home measures permanent for some staff. Retailers like Premier Investments are outright refusing to pay landlords rent whilst enjoying the protection of eviction moratoriums, all the while consumers flock to online shopping during lockdowns.

But Pete Morrissey of APN Property Group says it’s not the first time that A-REITs have dealt with existential threats. As consumer behaviours change, savvy landlords will adapt, and the office will not be a relic that people remember by watching… “The Office”. In this Q&A, he shares some of the compelling value opportunities in the A-REIT sector today as it resets for the future. 

Access the video or written Q&A below.

Shopping malls have been hit by the perfect storm. What do you make of their future?

The future of shopping assets is going to vary. Clearly the large malls that Vicinity (ASX:VCX) and Scentre Group (ASX:SCG) own have been severely impacted with their foot traffic numbers declining significantly with the lockdown that has been put in place, but these malls will recover at some stage. In the meantime, we've got more convenience-focused centres which are underpinned by supermarkets, which have been going gangbusters. Their performance has been really strong.

And so, a lot of people are going to those types of smaller centres and the returns or the performance of the supermarkets, the chemists, those types of things have underpinned those landlords. And their landlords are Charter Hall Retail (ASX:CQR) and Shopping Centres Australia (ASX:SCP), which have strong exposures to Woolworths and Coles primarily.

So there's a real deviation in the outcomes that we're seeing right now, but that's in the short-term. In the medium to long-term we will get a reversion back to the normal patterns that we've seen in the past. Some of the smaller tenants, obviously, will face pressure and may not come out the other side of COVID-19. Landlords right now due to the Leasing Code of Conduct, have a lot to deal with in retail land primarily, but they will come out the other side with the significant support that the government has put in place.

You’ve previously said that past pandemics haven’t deterred consumers’ propensity to go to the mall. Is it different this time around given the ease of online shopping?

Certain categories have suffered from online more quickly than others. We can all recall books, travel. Those types of things have really been impacted by online, whereas things like apparel, it's been a lot slower but that is occurring. But what we're seeing from the really good landlords in this regard is that they continue to reinvent the shopping centre. Over time, Westfield, the Chadstones of this world, Bondi Junction, those types of centres, if you visit them on a fairly regular basis, you'll see a regular turnover of tenants that occurs as they continue to reposition those centres to meet consumer demands.

And that's the key thing. These guys have done this for decades in some instances and I feel that they'll continue to do so. As you can see, in more recent times, we've seen a lot more emergence of food and beverage, entertainment, as the centres become more destinational.

There will be a recovery in a lot of the good landlords and the centres that they have, but they'll have to have a really good look at what they've got on offer now, where rents are and then try and ensure that they are in the right place to meet what consumers want going forward.

Will landlords need to go through an adjustment period as they cycle through new tenants and refit shopping centres; and what will that mean for rents and the end income A-REIT investors?

We've seen negative rent reversions occurring for Scentre Group and Vicinity for a number of years due to factors such as weaker consumer sentiment and low wages growth. We’ve had periods of weaker residential housing performance and we'll probably see that again. So, that is all a headwind for retail.

But also, there's this ability to continue to reinvent these centres for good landlords. Rents will be harder to get, but there's new opportunities as well for many of these guys. And also, the real recognition by good retailers themselves that you need both an online model and a bricks and mortar model to be very successful in most categories of retail that are out there today.

An increasing number of businesses are questioning the need for dedicated office space given what we've seen with work-from-home technology. What’s the future here?

I feel that there'll be a range of views around this. Some tenants and some of us ourselves will be quite happy to spend more time working from home, but many others, I'm sure, won't ever want to work from home again and perhaps have seen this as a real barrier to getting business done in the way that they normally do. They're not able to do so in the current environment and will be quite happy to revert back. So, there'll be a mixture of outcomes, I feel.

But in general, I feel the office space is really important. The landlords in office for many years were quite bland in what they provided their tenants. But in the last five to 10 years, there's been a really significant improvement and recognition that you've got to have good space to get really good outcomes, good collaboration, good ideas to get your business performing to its maximum.

Similar to retail, do you expect an adjustment response from offices?

Right now that move that we've seen in the past two or three years to flexible spaces, the benefits that brings many small businesses, is turned off for an office landlord from rent because those people aren't there. They're on a very short-term lease with the provider of that space within the building.

But I think a lot of those people will come back. The benefits that that space brings with flexibility for a small business owner to be in amongst where their clients are, to have a really strong face to their business, will be increasingly important.

How do investors navigate the A-REIT sector through this environment?

I think that's a real opportunity for investors that can see through this. Those are the that has seen the sector recover 25% from its lows as that aggressive, indiscriminate selling that occurred was seen to be overdone and is now beginning to unwind. There is a lot of water to go under the bridge, without doubt, but the real estate sector is perhaps at the forefront of this and may see the sunlight of the other side of COVID-19 and its implications sooner than many other businesses.

It's important to remember the government has so far unleashed $320 billion in stimulus spending, equating to around 10 per cent of GDP – larger than any support package provided by an Australian government.

This support will help Australia and the AREIT sector get through the impacts of COVID-19. Some things won't be the same on the other side but real estate will remain a key component of how Australia conducts business. The March sell-off presented significant value opportunities for long term investors willing to stomach the risk of the unknown.

What are you expecting for the REIT sector from an income perspective and also long-term, what type of yields can investors expect?

Based on our numbers, and it is very difficult to know without the Leasing Code of Conduct, the negotiations are only just beginning. So really, we're not going to know the outcomes until the REITs provide clarity on what their distributions are for the second half and then hopefully some guidance for FY21 in August. So, there is a lot of water to go under the bridge. 

Realistically though, some of the REITs are going to be quite significantly impacted. As I said, those mall names like Vicinity and Scentre and that's been really reflected in their prices. But going forward there will be a stabilisation period through the next year to 18 months for the sector. Then from that, we'll be able to grow, hopefully in a sustainable, steady manner, the majority of that return coming from that income going forward.

The key for many investors will be the fact that the yield that they provide compared to other asset classes, cash, term deposits and fixed income, will be very attractive. That will continue and that'll be a key benefit for many investors seeking to invest in the sector now or in the in coming months because the uncertainty is the opportunity for many investors as well.

Based on APN’s forecasts, the AREIT sector offers a yield of over 6.0% (7.0% ex-Goodman) for FY21. To highlight the strength of this yield, in 2010 the 10 year bond yield was 5.7% with the AREIT yield 0.5% higher. Contrast this with today’s 10 year bond yield of 0.86% against AREITs staggering 5.0%+ higher (6.0% ex GMG) yield. These forecasts are conservative, however, even if the recovery takes longer than expected and AREIT yields are lower, there is still significant long term value on offer for investors looking beyond COVID-19.

Do you think the sector has bottomed?

April saw a strong recovery as the sector was oversold, with offshore investors re-emerging on the back of an improving A$ driven by the Australian Government’s significant stimulus response and the realisation that the country is in a relatively solid position to emerge from COVID-19.

Can you talk through how the APN AREIT Fund is positioned?

We are underweight industrial, but our mandate inhibits us investing into active businesses such as Goodman, as an example, which is really the industrial exposure in Australia. Goodman only collects 30% of its earnings from rent and its payout ratio is around 50%, hence the yield is 2.3% as we sit here today. So that's a very, very low yield for us at those active earnings. As an income-focused investor, we want to be focused towards names that are going to provide more yield for us going forward. And so, that gives us a skew.

Within our retail, the composition for us is really important. We've got a really strong bias and our big overweight positions are in those names which are the non-discretionary type neighbourhood shopping centres that I mentioned earlier. We're underweight Scentre Group and Vicinity because we feel there is less certainty in their earnings in the shorter term.

On the office side, we've got stronger weights towards the smaller cap names that have higher components of government tenants, as an example, that we feel are going to come through this and continue to pay their rent in a very strong manner.

Can you give me two or three of your favourite REIT names?

One of the best I feel for us is Centuria Industrial (ASX:CIP) because it is a specialist industrial name. We really like that opportunity that that provides, a good consistent management track record. They're working those assets hard and we feel for right now that the capital values in industrial will hold up pretty well. And the other is Viva Energy REIT (ASX:VVR), which is going to be renamed in the near future. That's a good stock because effectively it’s petrol stations; obviously they've become more convenience retail-focused over the more recent years and while petrol volumes are down, that doesn't matter. They're still paying the rent and that's what we like to see.

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