The AREIT reporting season for the 2019 financial year (FY19) has just ended. To most in the market, it was in-line with expectations, perhaps to the point of being dull. At APN, that’s exactly how we like it.

Looking under the hood, sector performance has been anything but dull. In FY19, the S&P/ASX 300 AREIT Index returned 19.4%, the strongest result in three years and 8.0% higher than Australian equities. That’s something to shout about.

It was, though, a tale of two halves. For investors seeking AREITs to add diversification to their portfolios, they delivered. Through the volatile last quarter of 2018, AREITs consistently outperformed the ASX 300 Index, as the chart below shows. At a time when volatility was high and a wintry outlook was forecast, AREITs offered a safe haven.

Then, in the second half, bond rates plummeted and there was a surge in interest in higher yields at lower risk. This drove unsustainably strong returns in the first quarter of 2019. A period of stabilisation followed but overall returns for the year remained exceptional.

Whilst such returns are a pleasant surprise, the real value of this reporting season is in the three factors that ensure the stocks in which APN invests will continue to produce the cashflow to pay our investors their monthly distributions;

1. Earnings and distributions growing at sustainable rates: According to JPMorgan, earnings per share (EPS) were up 3.6% in FY19 and are forecast to grow by 4.4% in FY20. Distributions (DPS) grew 3.2% in FY19 and are forecast to grow by 2.1% in FY20.  With the low growth environment that persists, earnings and distribution growth of this magnitude is a good outcome for investors.
2. Debt levels remain low: Gearing across the sector was 25.6%, slightly lower than FY18. This pushes debt to its lowest level since 1999 and well below the long-term average of just under 30%. AREITs are well positioned to deal with higher interest rates, should they eventuate, with average debt terms of over 4.8 years. Debt diversification (reducing reliance on bank debt) remains a key focus of AREIT management teams. While longer term debt comes at a higher cost, it delivers the added cashflow security of knowing what the cost will be for the term of the debt.  A key factor to behind the predictability of AREIT cashflows which makes them appreciably safer.
3. Asset values are rising: Net tangible asset values (NTA) were up 5.4%¹ over FY19. Industrial and office assets enjoyed the largest increases and while retail was weaker, there was a divergence in underlying asset types; regional and convenience-based centres are faring better than sub-regional assets whilst west Australian assets and some regional locations are experiencing lower valuations. Further reductions in interest rates are expected to provide support to capital values in FY20, with further increases for industrial and office asset values expected.

From an earnings and debt perspective, the above table shows strong outcomes for AREITs although, as usual, sector metrics vary. Such differences are a good thing, smoothing the sector’s earnings profile and reducing volatility. Let’s take a look at each sector more closely.

Office still at full speed

A perennial underperformer for years, the office sector continues to roar. Office vacancy rates remain at or near record lows in Sydney (4.1%) and Melbourne (3.8%). It really doesn’t get any better for office landlords. With the negotiation table tilted significantly in their favour, landlords continue to increase rents (thus growing net property income) at rates well above long-term averages.

New supply is emerging for Melbourne later this year with further stock being added over the following years. Sydney’s new office supply will also ramp up next year. These new assets look well-positioned with generally high pre-commitment levels in both markets.

Owners facing tenant departures, however, will have lots of space to re-let, adding significant costs in terms of capital expenditure and incentives to secure new tenants. They will also be competing with new assets looking to maximise their occupancy from leasing any remaining vacant space. At some stage, this may prove a headwind to the prolonged period of above-trend rental growth landlords are enjoying.

Income growth of 5.6% for the rolling year (up from 3.7%) highlights the strength of some rental markets. Tenants in Sydney and Melbourne are facing market rents up to 40% higher when renewing their leases. With limited options to move elsewhere, they have little choice but to pay up.

This is not the case in Brisbane and Perth. Vacancy rates of 14% and 21% respectively mean tenants have a bigger say in their leasing outcomes.

From a performance perspective, the office sector returned 33.4% for FY19, led by Dexus (up 39.4%).

What’s next for industrial?

While office markets were strong the industrial sector was the real market darling last year, delivering a return of 57.7% over FY19.

The sector is dominated by Goodman (GMG), now the largest AREIT in Australia but unconventional in terms of owning Australian assets and distributing rental income to investors through distributions (see AREIT Index Misleads: The Goodman Effect).

GMG is now a highly successful global real estate operating company developing and managing assets across Asia, Europe/UK, North America and Brazil. Only 34% of its earnings are sourced from rent collection with around 40% of this figure being sourced from Australia. The remaining 66% of earnings are generated from development and funds management fees. Currently transaction and performance fees are at or near record levels but understanding their sustainability over coming years is our biggest challenge.

GMG’s earnings have moved so far from that of a traditional REIT the FTSE/EPRA Global REIT Index will remove GMG as a member on 20 September 2019.

This makes sense. Corporate earnings like transaction and performance fees just aren’t as reliable as collecting sustainably growing rents from high quality tenants that have committed to a lease agreement. Income investors in search of stable and reliable income should not assume GMG is a typical AREIT.

The barbell effect still impacting retail

After the half year results I discussed the barbell effect in retail. At one end are high quality super-regional and regional centres that dominate their catchments – Vicinity (VCX), owner of Australia’s largest shopping centre (Chadstone) and Scentre Group (SCG), owner of Westfield shopping centres in Australia. At the other end are convenience centres close to home owned by landlords such as CharterHall Retail (CQR) and SCA Property (SCP).

Both remain good places to be because the barbell effect still holds. One end enjoys higher occupancy rates and stronger sales growth whilst convenience centres source most of their rent from big supermarket chains. Both offer a high degree of income security over the long term.

Stuck in the middle are high street shops (thankfully not owned by AREITs or our Funds) and sub-regional centres that lack the accessibility of local centres and the product range and experiences of destination centres.

With limited differentiation and convenience factors, particularly parking, high street retail is being hit hard by the growth of online retail. Sub-regional centres, meanwhile, remain at risk from cannibalisation from each end of the barbell and online.

Landlords need to position their assets to capture changing consumer spending patterns and expectations. Scentre and Vicinity do this better than most with more food, services and experiential retailing options and with a reduction in categories more susceptible to online retailing (apparel, books, discount and department stores, for example).

Convenience centres must focus on being just that. Shoppers will continue their regular visits if they remain easy places to get your everyday needs.

With GDP growth at 1.4%, inflation at 1.6% and subdued wages growth, consumer sentiment remains weak. This makes the retail environment tough, reflected in net operating income (NOI) growth of 1.9% over FY19.

There are, however, a few unique factors. The return of the Liberal government has turned residential property sentiment to the positive. This should flow through to retailers at some stage, assisted by tax cuts. Indeed, positive signs in this regard were evident in August figures.

Cyclical problems remain but the right types of retail assets continue to provide APN investors the security and stability of distributions they have become accustomed to over the past two decades.

What else?

As market conditions improved and investor appetite increased, AREITs became extremely active in raising capital in FY19. Over $3.7bn was raised in the first six months, with $1.7bn raised in June alone. This is the largest amount of equity raised by the AREIT sector since 2009, a clear sign of investor demand for real assets that provide solid income and sustainable growth.

This demand was also reflected in the IPO of the Investec Australian Property Fund (IAP) in May. The stock has been welcomed into the sector with investors attracted to its diversified portfolio of industrial and office assets and 6.5% FY20 distribution yield. A 14% share price rise between listing and the end of August highlights investor demand.

More AREIT IPOs are in the works. Home Consortium, a portfolio of 30 large-format retail properties and a forecast fully-franked FY20 distribution of 6.0%, is to list in October though this will not be a REIT.

Aventus (AVN), its closest peer, offers a 6.3% distribution yield and income (NPI) growth of 3.5% for FY19, the strongest of all retail AREITs, proving that not all retail is created equally. Healthcare and diversified AREIT opportunities are also being investigated for future public offers.

All up, the AREIT sector remains in good shape. Providing investors with secure income through adept risk management is paramount to most AREIT management teams. And in this environment, why wouldn’t it be? APN’s AREIT Fund offers monthly distributions and a 5.79%² distribution yield and is a great way to get exposure to the AREIT sector providing more income with less risk.

* Current running yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.

This article has been prepared by APN Funds Management Limited (ACN 080 674 479, AFSL No. 237500) for general information purposes only and without taking your objectives, financial situation or needs into account. You should consider these matters and read the product disclosure statement (PDS) for each of the funds described in this article in its entirety before you make an investment decision. The PDS contains important information about risks, costs and fees associated with an investment in the relevant fund. For a copy of the PDS and more details about a fund and its performance click here. To receive further updates and insights from the APN team, sign up for Review, our monthly email newsletter.

1. Source: JPMorgan

2. As at 16 September 2019. Current yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.