This sector beat the ASX 200 after 5 of 6 rate peaks. Here’s Bell Potter’s ETF pick to play it

Australian interest rates have either peaked or are close to peaking, and this is presenting an attractive setup for a tactical rotation into listed property, according to Bell Potter.

Head of Investment Strategy Rob Crookston believes last week’s 0.25 percentage point increase in the cash rate to 4.85% - the highest level in 18 years - marks the top of the tightening cycle, but one more quarter-point hike is still possible if inflation proves “sufficiently persistent.”

“Monetary policy is already restrictive and there are growing signs that economic momentum is softening,” he says.

“The RBA will also be increasingly wary of overtightening into a slowing economy and unnecessarily increasing the risk of recession.”

If the thesis is correct, then Crookston believes that the investment opportunity is beginning to shift towards real assets and domestic bonds.

I covered the broker’s key fixed income ETF picks in a previous wire. Here, I dive into why Australian real estate investment trusts (A-REITs) could have their moment in the sun after a long time and how to play the opportunity.

The factors making property attractive right now

There are three factors that are improving the risk-reward equation in Australian listed property.

1) Interest rates peaking

The sharp rise in rates and bond yields has been a significant headwind for listed property, lifting discount rates, increasing financing costs and reducing the relative attractiveness of property cash flows.

“Much of the sector’s de-rating can therefore be attributed to the change in the interest-rate environment rather than a corresponding deterioration in underlying property fundamentals,” Crookston says.

As the rate cycle matures, these headwinds should moderate, Crookston says, adding that the investment case for A-REITs “does not require an aggressive easing cycle.”

Interestingly, across the previous six peaks in the cash-rate cycle in Bell Potter’s analysis, Australian listed property outperformed the broader ASX over both the subsequent three and twelve months in five instances.

Excluding March 2008, when the rate peak preceded the most severe phase of the GFC, A-REITs outperformed by an average of approximately 3.8 percentage points over three months and 11.7 percentage points over twelve months (see below).

2) Yields and valuations are attractive

On the valuation front, as the charts below show, A-REITs appear to be cheap versus the broader ASX 200 and are also trading at a discount to their net tangible assets (NTA).

And interestingly, Crookston observes that recent transactions in the sector have been conducted broadly in line with NTA, and as such, there is little evidence that property values are deteriorating.

“The sector does not need to return to historically elevated valuations for outperformance. A more modest normalisation in valuation multiples, combined with distributions and underlying earnings growth, should still produce attractive total returns,” he says.

And to income investors’ delight, ASX 100 REITs outside of Goodman Group are offering an average yield of ~5%, so investors are getting paid to wait.

“While valuations may not re-rate straight away, this income, coupled with a modest re-rate, could lead to double digit returns over the next 12 months.”

3) Constrained supply to push up rents

Finally, Bell Potter points out that “the economics of adding new supply are challenging” amid elevated construction costs, expensive debt servicing and more restrictive development economics.

As such, the supply of good new buildings is constrained and, combined with low vacancy rates, this leaves REITs well-positioned to capture rental increases as leases expire.

“In our view, this differentiates the current opportunity from a simple duration trade. REITs can benefit from a more favourable interest-rate environment, but they also retain the potential to grow income through tight supply and higher rents,” Crookston says.

How to play it?

The broker’s preferred way to play the opportunity is via the VanEck Australian Property ETF (ASX: MVA).

“MVA provides diversified exposure across the Australian listed property market while limiting reliance on any single company or property sub sector. We recently added MVA to our ETF portfolio,” Crookston says.

The broker prefers MVA because it avoids the concentration risk embedded in comparable ETFs from Vanguard and State Street, which rely on a market-cap weighted methodology — leading to Goodman taking up ~40% of their portfolios.

In contrast, MVA caps each A-REIT’s weighting at 10% while holding 13 securities.

“Capping low-yielding GMG gives MVA a higher dividend yield than the REIT index, with distributions paid twice a year ... with greater weight in rate-sensitive retail, office and diversified REITs, MVA should be a more direct beneficiary of peak rates than the GMG-heavy index.”

The ETF charges a 0.35% management fee and has nearly $900 million in assets.

For those who want individual stock ideas, the broker offers two picks.

1. GPT Group (ASX: GPT), with ~$41 billion under management, is trading at a 10% discount to its net asset value while offering a 4.9% yield. The property giant is evolving from a property owner to an owner-manager with a quality logistics, retail and office platform.
2. Charter Hall Group (ASX: CHC), meanwhile, has over $90 billion under management across over 40 investment vehicles, and its asset-light, scalable model is attracting growth mandates from large pension funds.

The company offers growth at an attractive price, trading at 18.5x earnings - in line with the market, but attractive given its quality, guided earnings per share growth of 10.5% and dividend growth of 6%.

While REITs are attractive, Crookston also emphasises that the case for adding fixed rate bonds and duration has strengthened.

“With the Australian 10-year government bond yield still at ~5%, bonds offer a much more attractive starting yield than they have for much of the past decade. This improves the return profile in a relatively benign economic environment, while duration provides additional upside if the economy slows more materially and longer-term yields fall.”