At the start of 2020,  few of us had heard of a coronavirus. That changed in early March when the World Health Organisation deemed the COVID-19 outbreak a global pandemic. After markets peaked in late February, a rapid and unprecedented sell-off ensued. The Australian 300 equities index fell 20.8%¹ while the AREIT 300 index declined a staggering 35.2%², the second-worst performing sector behind Energy which was down -37.5% in one month. The sell-off was unparalleled.

It wasn’t only investors that were panicking. Supermarket queues highlighted the desperation. With investors facing nauseating levels of volatility, it was hardly surprising that toilet paper was the big-ticket item!

The performance of AREITs in March was a shock, the decline exceeding by 10% the worst previous fall in October 2008. Whilst Australian REITs were down by over a third, Global REITs fared better, falling by -20.1%³ with Asia the standout, down a mere 15.4%⁴.

The Australian REIT market reaction was extreme. Inflaming the sell-off were the sector’s high retail exposure, double that of most offshore markets (31% vs. 16% globally). COVID-19’s spread and the lockdowns it provoked put retail in the gun sights. Retail REITs plummeted over 46% in March lead by the large mall landlords Scentre Group (-54.8%) and Vicinity (-52.1%), dragging the AREIT market down with them.

Due to the sector’s relatively high distribution yield, Australian REITs have traditionally been a happy hunting ground for offshore investors. When the virus hit, though, many ran for the hills, encouraged by the Australian dollar reaching a low of USD$0.55.

With the world facing an unprecedented health and economic disaster, central banks undertook wide-ranging measures to counteract the adverse impacts. The RBA cut rates twice in March to what was then a record low of 0.25% and governments embarked on major stimulus packages, including widespread income support for those facing extended lockdowns. The world as we knew it changed rapidly and remarkably.

How APN responded

At APN, our response was to actively reposition the portfolio early in the crisis. Many countries were suffering from the impacts of the pandemic before it hit Australia. That allowed us to evaluate the impacts overseas and make portfolio adjustments before it fully hit home. The first was to accumulate as much cash as possible to protect investor capital. At the end February the Fund held 3.3% cash which may not sound much but our long-term target is 1-2%. Through March the Fund reached its maximum cash position of 10%, finishing the month at 8.2% as we began redeploying proceeds as the market stabilised. By the end of April, we were back at 3.3%, with cash further reduced to our long-term target range (1-2%) over recent months as we sought to maximise our exposure to the market as pandemic concerns diminished.

In commercial real estate, there was a clear pecking order of impacts. Tourism, or the absence of it, was at the top of the queue. Whilst Australia lacks dedicated listed hotel REITs, all hotel chains have been badly affected. Retail was next, although the impact varied with property type. Convenience and large format retail, for example, suffered less than shopping centres, and in some cases prospered.

The same variation can be seen in the office sector. With central business districts almost empty, city centre offices suffered more than metropolitan locations. But with people working from home and unable to spend in restaurants, cinemas and other places, online shopping boomed, making industrial REITs the most defensive play.

On reflection, it’s incredible to see how quickly the history and quality of a stock was thrown out the window. The primary focus of investors became a game of trying to work out how each sector was going to survive COVID-19, with retail losing heavily, office less so and industrial the clear winner.

That’s easy to see in retrospect but at the time no one could say for sure it was going to play out that way. Without a knowledge base about the impact of a pandemic, very early on we set about building one. This allowed us to make some key portfolio changes, without moving too far away from the Fund’s investment objectives.

Chart one highlights the adjustments we made by real estate sector type over the past year. Most notable is the change in our exposure to retail, which was reduced from 55.8% of the fund to a low of 34.1% in July. The non-discretionary component of our remaining retail exposure grew to almost 60% due to our belief in the defensive cashflows of these assets. The release of these funds allowed us to increase our exposure to industrial and specialist REIT sectors which were to prove far more defensive through COVID. We have had to adapt to this rapidly changing environment thus as our confidence in the re-opening trade has grown our retail exposure been increased (39.0% by the end of November). One cannot sit still for long!

APN AREIT Fund Sector Allocation

Source: APN Property Group

Prior to the pandemic, the case for retail AREITs was strong, especially given APN’s yield-focused style. The sector typically features higher yields, income stability and long-term, sustainable growth. Whilst retail was impacted by low wages growth and the rise of online retail, population growth, assisted by immigration, and high barriers to entry meant retail could be expected to deliver reliable, solid returns.

COVID upended that notion. Lockdown meant only essential services were open to trade. Supermarket-anchored centres fared okay but the larger malls with more speciality tenants, food & beverage and services were hit hard.

The Government’s Leasing Code of Conduct, which meant landlords were one of the few groups required to assist their customers (12,000+⁵)retail tenants receiving rental assistance from their landlord) through the depths of COVID, added to the pain. Large mall owners suffered rent collection rates of less than 30% while foot traffic tumbled over 80% in some centres. It was an unprecedented disaster for retail landlords. The silver lining for those tenants with an omni-channel offering (stores and online) was an explosion in online demand.

Leading into and through the initial stages of the pandemic, we reduced our exposure to this end of the sector. We had a far higher degree of comfort in owning convenience and large format retail than we thought would benefit from having income underpinned by supermarkets and other categories that thrived in lockdown.

Rent collection rates (refer following chart) validated this thesis with larger regional mall landlords averaging below 45% in the June quarter while convenience/large format collected over 80% of cash rent for the same period. With Australia’s success in managing COVID-19 and the subsequent state border openings, rent collection rates averaged 75% for the September quarter and continue to improve. The prospects of an imminent vaccine should buoy the retail sector leading into what should be a strong Christmas trading period.

What of the office sector? Personally, I found being holed up in a home office watching the carnage in financial markets unfold a frustrating and disheartening experience. Regular Zoom calls with colleagues was not an ideal way to decipher what was unfolding. Give me the GFC’s intimacy and tenure versus a COVID-19 financial and health crisis cocktail any day.

The WFH scenario saw some adapting perhaps a little too well while others longed for the water fountain banter, looking professional in long pants or walking outside to get lunch. We are thus all experts on how future office occupation will unfold, which is perhaps why it remains so difficult to predict.

Prior to the pandemic, the Sydney and Melbourne office markets had experienced a long up cycle. History shows that economic corrections act as a circuit breaker in these periods, in which case COVID-19 may have just blown up the switchboard. Fortunately, hard evidence in the form of transaction values suggests that capital values have remained reasonably stable.

Still, vacancy rates and incentives have risen rapidly and rents are coming under pressure, although many tenants are waiting to see how things play out. Our view was that CBDs, with their significantly higher rents and new supply, could face more downward pressure. We therefore directed our office position towards metropolitan markets which have a higher proportion of government and lower SME tenant base (at least in the AREITs we own). The portfolio’s overall exposure to office moved around as we repositioned, although this was primarily due to market movements.

AREIT Cash Rent Collection 2020

Retail Rent Collection – June Quarter

Source: Bloomberg November 2020.

Other major portfolio adjustments were also required. Lockdown provided an unparalleled opportunity for online sales to explode. Logistics facilities and warehouse owning AREITs were doing well before the crisis but took off once it got underway. One of the results is that Goodman Group now represents 24.4%⁶ of the AREIT300 index. It yields around 1.6% and trades on a staggering multiple of 30x.

For an income, value-biased manager like us, Goodman has long been difficult to digest. We wanted more industrial in the portfolio but with less than 30% of Goodman’s earnings coming from rent collection (the balance is from development and funds management) and with most assets held offshore, we found other places to grow our industrial exposure, which is now almost 70% higher than pre-COVID times. But, as the saying goes, you can’t fight the Fed and in AREIT land Goodman is a mini-version of it. As a result of adjustments to our mandate limits, we also increased our Goodman weighting. This is great for our industrial exposure, but we are unlikely to get anywhere close to market weight in this name as we could not deliver on our primary income objective of providing at least a 10% higher yield than the index.

Specialist REIT sectors have also performed well. Service stations remained open and their lease structures meant lower fuel volumes didn’t impact rent payments under lockdown. Our portfolio allocation to service stations has increased over 180% since the start of COVID and we’re still happy to collect high yields from this defensive asset class. Over 2020 transaction volumes are up 55% (year to date) highlighting we’re not alone in our enthusiasm for this niche.

Childcare REITs also benefited from government stimulus, as have hotels (the pub kind). In the June quarter, rent collection rates were between 85% and 96% respectively. The rural REITs, while only a small component of the market, enjoyed 100% rent collection as the demand for primary produce grew.

This kind of operating result across sectors, though, was unusual. COVID-19 has proven to be the greatest disruptor we have ever seen. Its impact is far from over and, as the northern hemisphere moves into winter, the situation globally is more worrisome than it is in Australia, where our hard work has made us the envy of most. As normality resumes, the news of a vaccine has seen our spirits boosted and our anxieties diminish.

Much the same applies to the AREIT sector, which has suffered more than most but is now on a recovery track. AREITs generally are built to last. The GFC hurt the sector badly but lessons were learned, especially with regard to debt management. AREITS bounced back bigger and stronger, delivering a return of 11.6% p.a. between 2010-19. This time around, they have proven their durability and capacity to adapt, as I believe the APN AREIT Fund has. Positive news through November saw AREITs rally a staggering 12.9% well ahead of equities at a mere 10.2%, which I read happened to be the best monthly return since 1917! While the March sell-off remains fresh in our minds, it’s great to see investors who stayed the course being rewarded for their resilience.

There will be much work to do for AREIT management teams but also many opportunities. With interest rates at rock bottom, yield opportunities are difficult to come by. With AREITs trading reverting to more normal patterns, there is now a little more certainty around the sector, which makes APN’s AREIT Fund, currently offering a 5.76%⁷ distribution yield paid monthly, a compelling proposition.

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. S&P/ASX300 Index.
2. S&P/ASX 300 AREIT Index.
3. GPR 250 REIT Index (AUD).
4. PR APREA Composite REIT Index Asia (AUD).
5. Shopping Centre Council of Australia 16 November 2020.
6. As at 30 November 2020.
7. As at 30 November 2020. Distributions may include a capital gains component. Past performance is not necessarily an indicator of future performance.