Investing in Australian real estate investment trusts (AREITs) is meant to be boring. The aim of the game is stable distributions that turn up like clockwork, with low share price volatility to match the predictable returns.
Over the past two years the sector has delivered on that commitment, and a whole lot more. Whilst the ASX All Ordinaries index is below the level of June 2014, the ASX 200 AREIT index has risen by more than a third. For investors in the sector and those attracted by the yields it offers, that prompts some key questions.
1. What’s behind the recent price rise?
We believe interest rates are the key issue. The ‘lower for longer’ argument refers to the expectation that global growth and inflation will be low for an extended period. Indeed, the emerging theme in financial markets is ‘even lower for even longer’.
That’s having a big impact on long term bond yields, which have hit record lows. Not only is this reducing the borrowing costs of the sector, it’s driving interest in AREITs. With global interest rates heading towards zero and in some cases going negative, investors seem more willing to pay up for yield.
With term deposits and Australian government bonds paying 2-3% p.a., the AREIT sector’s average current yield of 4.50% p.a. is comparatively attractive. We believe there are few places where you can find a yield of this quality and number. That’s what’s driving interest in the sector.
2. Can the rally continue?
If interest rates continue to fall, we believe, yes. We expect the ‘lower for longer’ theme to play out for some years yet. This would be good news as lower rates are likely to equal further price rises.
Why? Because, depending on which valuation tool you use, valuations are not yet stretched. Net Tangible Assets (NTA), a measure which many analysts prefer, indicates valuations areexpensive. But we believe this is a distorted figure due to the impact of stocks like Goodman Group (ASX: GMG) and Westfield Corporation (ASX: WFD), which include significant amounts of corporation earnings – those delivered by property development activities rather than rents. These stocks trade at significant premiums to NTA (as much as 70%-100%) and represent around 26% of the AREIT sector, distorting the overall market premium to NTA. There are still a number of AREITs that trade below NTA.
Moreover, AREITs are liquid assets not liable for stamp duty and legal expenses, which can be as much as 6% of an asset’s value. A ‘neutral’ 10-15% premium to NTA isn’t unreasonable. Exclude Goodman Group and Westfield Corporation and the sector’s premium to NTA is 24%.
Although common, NTA is far from a perfect tool to value stocks. Many AREITs are structured with securities in a trust and a company ‘stapled’ together. Both parts should be valued separately. The Net Asset Value (NAV) does that. It indicates the sector is trading around fair value. Further, future growth in rents and asset values should deliver further increases in NTA.
And if you believe that interest rates will stay low for an extended period, our valuations imply value in the sector.
All up, the recent surge in AREIT share prices seems to have a foundation and we believe the fundamentals remain attractive.
3. What if interest rates rise?
AREIT share prices would probably fall, just as they have risen as rates have fallen. Eventually, rates will rise but in our view that’s years away. And even when they do, the typical lease agreement (market based resets at various points) may mitigate against this impact.
Generally, interest rates rise to inhibit an overheating economy. When the economy is strong it normally translates into higher rents. As rents grow it flows through to earnings, paid out as dividends, or distributions as they’re called in the sector. AREITs can therefore mitigate somewhat against increasing interest rates, especially when compared with fixed interest, where the income return is static.
4. Is the AREIT market reminiscent of the pre-GFC period?
Definitely not. Debt is now lower and better managed, with a greater diversity and longer tenure. The earnings that AREITs produce are driven by rents rather than ‘corporate’ earnings, where previously the sector chased over-priced assets. Overseas earnings are significantly lower and management teams more realistic and sensible.
We believe the key risks that were substantially responsible for the magnified impact of the GFC on the AREIT sector are now far lower than in 2006-7. The sector has returned to its roots and is all the better for it.
5. What’s the outlook for AREIT distributions?
We expect steady increases in distributions from the sector based on lower interest charges (due to lower interest rates), underlying rental growth and potentially accretive acquisitions.
Short to medium term price spikes and dips will occur but if investors take a 5-7 year view as we recommend, low volatility income and growth in total returns is quite achievable. APN’s objectives are to deliver income, low volatility, tax-advantaged income and capital growth to our investors. Despite this period of strong AREIT share price rises we’re confident we can deliver on those objectives.
6. Which parts of the sector have the best prospects?
We believe there’s long term value in retail property. High barriers to entry typify much of the sector we’re invested in. Investments in super regional shopping centres like Chadstone and Bondi Junction are likely to perform strongly. Well located and managed assets that cater to daily shopping needs may also provide a steady earnings stream. Office portfolios exposed to the strong Sydney and Melbourne markets should deliver growth in earnings, too.
But you’re better off in a diversified, balanced portfolio of AREITs than trying to pick individual winners. Diversification is just as important in this sector as any other, which is what the APN AREIT Fund is all about. And for those investors seeking geographic diversity away from Australia, the APN Asian REIT Fund, currently featuring a running yield of 6.10%1 p.a., offers exposure to Tokyo, Singapore and Hong Kong, some of the biggest commercial office and retail markets in the world.
7. What are the key themes to watch next financial year?
Well, ‘lower for longer’ is likely to dominate. We agree with the Reserve Bank of Australia that inflation will trend lower and that GDP growth will not be above long term trend. We expect income investments to remain popular as a result.
If asset values continue to rise, debt, as a proportion of gross assets, should fall for most AREITs, allowing them to borrow more (at low interest rates) to acquire more assets. Correspondingly, we expect growth in AREIT portfolios should deliver higher earnings and greater diversity.
Mergers and acquisitions may be a possibility in coming years. GPT Metro Office Fund (ASX: GMF) is currently being pursued by two suitors and we expect to see more of this kind of activity. Following the market rebuff to the Dexus Property Group’s proposal to take over Investa Office Fund (ASX: IOF) we expect these transactions to be earnings positive to the target or run the risk of failure.