There’s only one word to describe the performance of the AREIT sector over the last financial year – sensational.
After the pandemic-induced pain of 2020, the best returns in over 20 years for AREITs and over 30 years for equities was adequate compensation. AREITs1 returned a stunning 33.9%, 5.4% ahead of equities. It may not have been a complete surprise, but it was most certainly welcome.
The recently completed reporting season offered further cause for optimism. The powerful recovery in earnings in the second half of 2021 led to a further 6.3% gain from the sector in August. For investors who stayed the course or saw the opportunity to buy at knocked-down prices last year, the quality of the real estate delivering attractive and reliable cashflows was there for all to see. Without doubt, AREITs are making a comeback.
For investors, the key takeaways from the FY21 reporting season are as follows:
1. Asset values up
Across the sector, net tangible assets per share rose almost 10%, the best performance in years. Cap rate compression was most pronounced in the Industrial, Childcare, Convenience/Neighbourhood Retail and Large Format Retail. Office cap rates were generally slightly lower with regional malls flat after significant increases (value reductions) in 2020. This provided some relief to owners, although the lack of transactions means the impact of COVID on asset values remains unclear.
2. Earnings revised down, but not by much
AREIT earnings were revised down by 0.9% on average. This was better than most sectors and the equity market, which saw earnings revisions down 2.7%. The forecast earnings growth for FY22 is over 10% as the COVID recovery continues. Some lockdown-affected stocks, primarily in retail, didn’t offer FY22 earnings or distribution guidance. This should propel above-average earnings growth into FY23 as the benefits of recovery spread.
3. Debt levels at historic lows
With high liquidity across the sector and low short-term refinancing risk, balance sheets remain healthy. Gearing is below 25%, near its lowest level for a decade. Many AREITs have gearing at the lower end of their target range. Further reductions in debt costs will be an earnings tailwind this financial year, too.
4. Occupancy depends on sector
Occupancy rates varied by sector. At an average occupancy of 98.3%, retail was more resilient than expected. Industrial occupancy remained high at 98.5% thanks to a demand surge while office occupancy slipped to 94.8% from 95.9% a year ago. This reflects new supply and the uncertainty around tenant requirements in a COVID world.
Let’s look at how the underlying sectors went.
While expectations were modest the reality was encouraging. Results from Retail AREITs showed sales rebounding as restrictions were lifted. Consumers are clearly keen to return to shopping centres when regulations permit. While further restrictions and mandated rent relief looms over the sector, investors are looking beyond it. Encouraging signs disclosed by landlords drove the sub-sector up 9.4% in August 2021, making it the best performer for the month.
With the leasing code reintroduced in Victoria and New South Wales, aside from Scentre Group and HomeCo Daily Needs REIT, landlords abstained from providing distribution guidance. Rent collection and rent assistance will be the key figures to watch this half.
Last year’s experience suggests that consumption will recover as lockdowns are lifted. As restrictions were eased in the first half of FY21, spending in services – especially domestic travel, hotels, cafés and restaurants – increased substantially. Discretionary consumption offers the prospect of a much-needed boost for the retail landscape in the months ahead as vaccination targets are reached. While things are not back to what they were, their outlook is improving with the inability to travel offshore providing a war chest to boost consumer spending.
Thanks to near 100% cash rent collection and stable asset values, office landlords reported satisfying results. Rental market dynamics remain challenging though, with occupancy declining across CBD portfolios and landlords offering greater incentives to secure new tenancies.
Green shoots were reported alongside these metrics as a pathway towards normalised operating conditions resume with broader reopening. Activity through the period saw most CBD focused landlords anticipate incentives will begin to decline over the next 12 months and are also expecting a continuation of the noticeable downward shift in the level of sub-lease space across key markets.
We were also particularly encouraged by the underlying operating resilience of ex-CBD or metropolitan focused office landlords, with several reporting an increase in occupancy through the period. In our view this reiterated the attractive proposition high quality, well leased metropolitan office portfolios can provide to investors.
Despite lingering uncertainty over the future of the office, there was a bounce back in the number of lease deals by listed landlords in the second half. This was in contrast to the prior period and suggests a template exists for tenants to commit to new leases as restrictions subside. In our view this corroborates the messaging from a number of major landlords that suggests corporate tenants are acutely aware of and willing to support the office as a key pillar to their operations in spite of the pandemic.
Investors in the direct market appear to agree. Pricing for high-quality, well-leased office assets saw cap rates remain tight, despite an increase in 10-year bond yields from historic lows (see chart).