The ASX REITs most exposed if rates stay high

The unemployment rate rose to 4.6 per cent in August, from 4.5 per cent in July, in today's announcement. 

Reserve Bank of Australia governor Michele Bullock said earlier this week that an unemployment rate of 4.5 per cent to 5 per cent could help restrain inflation.

Whether this has any impact will be revealed soon, when the RBA board meet on 29th September.

Morgan Stanley is expecting the RBA to lift rates by 25bps to 4.6%, while markets expect the cash rate to stay above 4.5% until at least December 2027.

Morgan Stanley analysts have assessed each REIT's FY27/28 interest rate hedges, and identified who is most exposed if rates remain elevated. 

Half the protection runs out

Morgan Stanley analysts went through the rate hedges each REIT disclosed in the August reporting season, excluding the fund managers (Goodman, Charter Hall, Centuria Capital, HMC and Lendlease) given their earnings are less driven by debt and rates, and their gearing is generally low.

Hedging lets a REIT lock in the interest rate on part of its debt. On average, the 17 REITs they cover have about 75% of their FY27 interest costs locked in. That falls to 51% in FY28 and 34% in FY29.

The expiring hedges are cheap - most were set at about 3.4%. Locking in a rate for one to three years now costs about 5%. That makes new hedges 1.5 to 2 percentage points more expensive than the ones they replace. 

"The alternative is for REITs not to hedge and just leave increased exposure to the floating rate (BBSW), hoping that rates will come down by the time FY28 rolls around....However, that would simply be the REIT taking a view on interest rates, rather than providing certainty to earnings" the analysts said. 

Their conclusion is that "if the market is right about the RBA – i.e. rates remain elevated for the next 6-9 months – then by the time FY28 comes around, every REIT could face either flat, or higher weighted average cost of debt, relative to FY27."

Who is most exposed

Morgan Stanley points to three groups:

• Dexus (ASX: DXS) and Mirvac (ASX: MGR) - Among the ASX 100 REITs, these two have the most FY28 debt on floating rates. Their hedged share falls by 24 and 18 percentage points. Their expiring hedges were set at 3.0% and 3.4%. If those are replaced at close to 5%, their borrowing costs would rise by at least 0.35 percentage points.

• The externally managed REITs - Outside the ASX 100, the analysts point to Charter Hall Long WALE REIT (ASX: CLW), HomeCo Daily Needs REIT (ASX: HDN), Charter Hall Retail REIT (ASX: CQR) and HealthCo REIT (ASX: HCW) are the ones to watch, who each lose between a fifth and two-fifths of their hedges in FY28. HealthCo's in particular drops from 54% to 13%, the steepest in the group.
  

• Scentre (ASX: SCG) and GPT Group (ASX: GPT) - Both also have large drops in hedging. But they report on a calendar year rather than a financial year, which gives them about six more months than peers before the higher costs start to bite.

When Morgan Stanley modelled a scenario in which each REIT tops its FY28 hedging back up to FY27 levels over the next six to nine months at a 5% rate, the hit to earnings per share ranges from 0.3% for GemLife (ASX: GLF) to 6% for Charter Hall Long WALE.

Inflation cuts both ways

Three of the most exposed names are partially offset by rents linked to inflation. At Charter Hall Long WALE, 54% of rent rises with CPI. About 40% of Charter Hall Retail's income is linked to inflation. Scentre's specialty leases outside Victoria rise by CPI plus 2% each year.

If rates are staying high because inflation is sticky, those rents rise too, softening the hit from higher interest costs.

The least exposed

GemLife, Arena (ASX: ARF), BWP (ASX: BWP), Centuria Office (ASX: COF) and Vicinity Centres (ASX: VCX) would feel the least impact, mainly because their FY28 hedging looks much like FY27. Arena is the best protected, with 100% of FY27 debt hedged and 93% of FY28.

However, Morgan Stanley rates Arena, Centuria Office and Vicinity all Underweight, so low rate sensitivity alone doesn't make them preferred picks.

What to watch

The analysts say it is probably too early to cut FY28 forecasts, given how quickly the outlook has changed over the past 12 months. But they add: "it is fair to say that FY28 downwards earnings revisions are a risk."

For the next six months, they prefer REITs with high hedging, such as Vicinity, or strong CPI-linked rents, such as Scentre. They rank both ahead of the housing-exposed developers Stockland and Mirvac.

The model assumes management does nothing. In practice, REITs can refinance at lower margins, lock in rates when prices dip, or sell low-yielding assets to pay down debt. Investors should watch for these moves, and for updated hedging at the February results.