Retail REITS And The (Invisible) Risk

Last week, I was reminded by a gold bug investor on Twitter that, as far as asset investment returns are concerned over the past two decades (1999-2019), gold came in a solid second, well ahead of the average equity or property market, but real estate investment trusts (REITs) have been the killer asset over the period.

The US-based investor in casu was soon vilified for his biased view in favour of gold, as is custom these days on social media, with the main accusation being he had strategically picked the starting date at the absolute bottom of the gold cycle throughout the 1990s. Pick a different starting date and the numbers look a lot less favourable for the shiny metal, posted a small dozen other investors in chorus. And I agree.

Surely every less-biased investor can easily see on historic price charts that gold priced in USD peaked near US$1900/oz in late 2011 and has been in a volatile side-ways moving pattern over the past three years?

But this story is not about gold, which came in second best over the whole period (thanks to its stellar rally from 1999-2011), it's about the number one performing asset; REITs. I don't think anybody would have guessed that REITS were the exposure to have for investors, even only a few years ago.

Contrary to gold, REITs number one position was acquired in recent years, from mid-2012 onwards to be precise. Whereas previously this segment of the share market was mostly seen as boring and extremely unexciting, considered prime hunting ground for unprepared retirees desperate for sources of regular income, in recent years this sector has become the number one outperformer that virtually nobody ever talks about.

In Australia, A-REITS have outperformed the broader share market in five out of the past six years, and the sector has continued to perform well in 2019. In case you wondered: 2017 was the year of AREIT underperformance.

This observation provides us with a few key insights: the heavy influence of Quantitative Easing (QE) and extreme low bond yields on global assets, but also how tough the challenges are for the rest of corporate Australia in the light of demographic shifts, technological disruption, extreme low interest rates, and the breaking down of cosy domestic duopolies.

But wait, there's more.

Not every REIT on the Australian stock exchange has been enjoying sustained outperformance since 2012. On my assessment, this is the result of this particular segment equally feeling the impact from the tectonic shifts impacting on the Australian economy in general. These shifts have divided REITS into winners and losers, just like the rest of corporate Australia. The winners, of course, are responsible for the bulk of the sector's stellar outperformance.

Think Charter Hall (CHC), and Dexus Property Group (DXS), and Goodman Group (GMG), but also Centuria Industrial REIT (CMI), and Rural Funds Group (RFF).

Have not been consistently among the winners, and seen their valuations de-rate in recent years, are the landlords of retail assets. While most investors' attention goes out to what the prospects are for the likes of JB Hi-Fi, Myer, and Premier Investments, the market has decided disruption and transformation are just around the corner for owners of shopping malls and other commercial properties that facilitate big box retailers such as Target, Big W and Dan Murphy's, or smaller boutique retail franchises.

The key problem here is that when shares in Scentre Group (SCG), Vicinity Centres (VCX) and Shopping Centres Australasia Property Group (SCP) -to name three of the obvious landlords on the ASX- are being left behind, their yield attractiveness only increases, in particular when investors stung by Labor's plan to abolish franking cash rebates are looking around for yield-income alternatives.

The problem thus becomes: to what extent have these landlords now become yield traps in a long-winded sector downturn?

On my observation, commercial property space is increasingly subjected to retail shops ceasing presence, if not operations, and it appears there are no quick replacements available. Most empty spaces I spot remain empty for a long time. And while shopping centres are doing a commendable job in replacing failing retailers with food courts, gyms, libraries, bowling centres and other alternatives, the question has to be asked: at what point can current leases no longer be retained, not to mention the necessity to mark down the value of current assets on the balance sheet?

The transformation that is currently hitting retail landlords is slow moving, and negative developments may not become visible for ordinary observers outside the sector for a long while. But retailers such as Premier Investments are responding to slower growth by closing down stores throughout Australia (the local Smiggle in my neighbourhood is no longer in operation), while big box retailers like Target and Big W, who take up a lot more space, are shrinking store numbers in order to remain viable.

The situation becomes a lot trickier if one takes into account that many of the diversified property owners in Australia are looking to sell their retail exposures (wrong timing, all at once) and recent analysis by Citi is suggesting too much additional retail space has been added ahead of what has now become a challenging downturn for bricks and mortar retailers.

In my view, this segment of the local REITs sector is now best categorised by that old Wall Street adage: none of this matters, until it does.

I note Citi's most recent sector update revealed Sell ratings for Scentre Group, GPT (GPT), Shopping Centres Australasia Property Group, Charter Hall Retail (CQR) and BWP Trust (BWP).

At the very least, I'd be wary of any buy recommendation for such assets on the basis of the stock looking "cheap", "relatively undervalued", or seemingly offering too attractive a yield to ignore. Better to be absent when the proverbial hits the fan, exact timing unknown.

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