Property: On the nose or smelling like a bargain?

It can take guts to voice unpopular views. Last Thursday, about 20 minutes into our team’s 9am weekly distribution meeting, someone said what everyone else was thinking: “property is just on the nose right now”.

That summed up what we had been hearing. Whilst some investors are still actively allocating funds to the sector, there was no doubt around our (virtual) meeting table that commercial property has lost support of late. But how bad has it really been?

The facts are that the listed property sector as a whole sold off by 44%¹ in March and some REITs raised capital in a big way. The sector has raised $4.9 billion in calendar 2020 to date and distributions have either been pared back or cancelled altogether. For investors over-exposed to particularly poor performers or concerned with short term volatility, this period must have felt reminiscent of the Global Financial Crisis.

Then the sector bounced back in resounding fashion, increasing by 56% from the end of March low to date. For the year to date², the ASX AREIT 300 Accumulation Index, which includes distributions, is down 4.3% while the general stock market (ASX 300 Accumulation Index) is down 1.2%. For those who’ve bought in for the income and stayed the course, that might not sound so bad.

Unfortunately, some have not. As noted in our reporting season wrap, this year has really been a story of AREIT winners and losers. This, in our view, highlights the importance of being able to pick and choose which REITs to own for the best prospects of reliable future income.

As an example, APN’s own Convenience Retail REIT (ASX:AQR), which holds a portfolio of service station and convenience retail properties, is trading 5.7% above where it started the year³. To add to that are cash distributions delivered at an annual rate of over 6% (total return of 11.7%)⁴. Specialised REITs, particularly those with long term lease portfolios in non-COVID sensitive industries, have also substantially outperformed, in stark contrast to many shopping centre retail REITs that have struggled.

If we have learnt anything from this period it is that there is as much diversity in commercial property as there is in any other sector of the market, and perhaps more. For investors seeking regular, reliable income this is a challenging environment.

Here are a few pointers to help income investors get to grips with the new terrain. The first is that the stocks and sectors that are getting all of the attention aren’t of much help. I am equally unsure whether the Afterpays of the world will double or halve from here but I do know they’re not much help for investors looking for reliable income.

The second is that, with the cash rate essentially zero and the dividends of the major Aussie banks – a traditional source of income for many – suffering big cuts and more uncertainty ahead, income investors face limited options.

On Melbourne Cup Day, RBA Governor Phillip Lowe directed investors to three important numbers to watch. The first the reduction in the RBA’s annual cash rate to a record low of 0.1% as of 3 November 2020. This means savers or deposit holders will receive even less income from money in the bank. The second number is three – the number of years the RBA has said it will hold rates at this level.

The third – $100 billion – is the amount of quantitative easing planned by the Reserve Bank, buying Australian Commonwealth and state bonds. This policy is aimed at keeping interest rates low. The amount sounds like a lot but on a global scale is comparatively small, which is presumably why the RBA held out the prospect of increasing it should circumstances require it. This points the way to a future of even-lower-for-even-longer interest rates.

Beyond the numbers are the reasons why interest rates are likely to remain low; the deflationary forces of ageing populations, technological disruption and a huge increase in global debt. One should also remember that central bankers have pockets of unlimited depth. Only the brave (or foolish) investor should bet against them.

These factors have utterly disrupted the lives of income investors, which is why it’s worth remembering a few salient facts.

Property owners are typically beneficiaries of lower rates because they lower interest costs, thereby improving free cash flow. For lenders like banks – a traditional source of dividends for income investors – the opposite applies. With lower interest rates to work with, profit margins suffer. The question for income investors is this: whose side of the argument do you want to back and what do you have to lose?

We cannot predict whether markets will go up, down or sideways. We do, however, appreciate the attractiveness in the property sector’s yield spread to cash. While the cash rate is next to nothing, the APN AREIT Fund has a current running distribution yield of 5.7%⁵.

That gap speaks to the respective risk and return profiles of each investment. But it’s useful to remember that the yield spread between cash and AREITs before the pandemic was a lot less than it is now. And, with the property sector having corrected earlier this year, many AREITs have recapitalised. With distributions rebased and with good and improving visibility on rental earnings from here, the gap between cash at 0.10% and the listed property sector at 3.95%⁶(and the AREIT Fund’s distribution yield above) is significant.

This point was not lost on one of our larger superannuation fund clients, who recently made the observation that if the property sector continued to deliver its yield over the next five years, they could afford to lose roughly 25% of their capital and still be ahead of the return on cash. For income investors, this is an argument worth contemplating from both sides.

On the one hand, rental income streams could be further tested, with a lower yield than expected and lower property valuations a possible result. On the other is the prospect of even lower or negative rates, which would result in values moving higher. Consider a property yielding 6% (eg worth $100 and delivering $6 per year in rent). If rent fell by 15%, and was coupled with a 1% reduction in the capitalisation rate to 5%, the value of the property would be about the same. (That’s $5.1 per year in rent at 5% gives you $102).

This is not to say a 15% fall in rents across the board is a certainty, although it’s certainly possible in some parts of the market – Sydney CBD office and regional shopping centres, for example, spring to mind. Instead, the purpose is to provide some context for how the sector is positioned in deciding whether to remain on the sidelines in cash or otherwise allocate your investment capital.

We hope these ‘big picture’ thoughts are helpful but note that examining the detail of individual investments, particularly the strength of rental rolls, remains essential. This is perhaps the key factor to establish in determining who to back as your investment property manager. It also happens to be at the heart of the way we have always seen ‘property for income’.

In any kind of investment activity, there are challenges and opportunities. Often one accompanies the other. This, we believe, is one such time. Commercial property is going through a difficult period, which is why there are some excellent investment opportunities available right now.

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Footnotes

1. Change in ASX300 REIT Accumulation Index 2 January 2020 to31 March 2020.
2. To 12 November 2020.
3. $3.70 closing price 12 November 2020 over $3.53 closing price 2 January 2020.
4. Past performance is not necessarily an indicator of future performance.
5. As at 12 November 2020. Distributions may include a capital gains component. Past performance is not necessarily an indicator of future performance.
6. ASX300 AREIT Index Distribution Yield as at 12 November 2020.