1. What were the best and worst performing stocks under your coverage in 2019?
Pete Morrissey (PM), CEO Real Estate Securities
Among retail REITS, large format retail (LFR) landlord Aventus (ASX:AVN) returned 43%* for the year. Not only was it the best retail AREIT performer but the fourth best performing AREIT overall. AVN highlights the divergence in performance that is occurring between different types of retail assets. Top quality management, a 6.0%*-plus dividend yield and sustainable earnings growth means AVN is likely to remain one of our biggest relative overweight positions (>4.5x index weight) in the AREIT Fund portfolio.
At the other end of the spectrum was Vicinity (ASX:VCX), with a disappointing 1.9%* total return for the year. Fortunately, this didn’t impact the APN portfolio too much. In early 2019, expecting a difficult year for the stock, we reduced our position, taking it from an overweight to an underweight holding. Assisted by adverse media headlines, Vicinity’s stock now yields over 6.1%*. As owners of Australia’s best shopping centre (Chadstone), a portfolio of strongly-trading Direct Factory Outlets (DFO’s) and other quality centres, we are comfortable with the stocks contribution to the portfolio.
Corrine Ng (CN), Portfolio Manager, Asian Real Estate Securities
Among stocks in the APN Asian REIT Fund portfolio, the best performer was data centre owner Keppel DC REIT, rising 53%* during the calendar year. This was a great result for the fund, Keppel DC being our largest overweight position. We still love the niche nature of the sector, its defensive operational profile and above-average distribution per unit (DPU) growth. Last year, an equity raising allowed the acquisition of two assets, both highly accretive to DPU, demonstrating management’s ability to operate in shareholders’ interests. Its inclusion in the FTSE EPRA NAREIT Global index in September 2019 no doubt also aided performance.
Fortunately, the fund’s worst performing stock barely impacted portfolio performance. We held a small, underweight position in Hong Kong-listed Champion REIT due to its high-quality assets, compelling valuation and dividend yield of 5.4%*. The social unrest that unfolded in Hong Kong hit sentiment (and therefore valuations), despite the fact that there hasn’t yet been a real impact on Champion REIT’s earnings or distributions. In the scheme of things, Champion REIT’s return of -4%* in 2019 wasn’t at all bad.
Mark Mazzarella (MM), Portfolio Manager, Real Estate Securities
The best performing stock from those I cover within the S&P/ASX 300 AREIT Index was diversified landlord, investment manager and developer Mirvac Group (ASX:MGR). It achieved a total return of 47.5%* through 2019, more than double the total return of the index as a whole. A few years back, Mirvac’s management team set a plan to organically grow its office exposure into one of the highest quality nationally, while shrinking its retail mall exposure to focus on more resilient urbanised locations. In 2019 year that plan bore fruit, assisted by the sector-friendly election result in May, which boosted the outlook of the residential development business.
In my area of coverage, GPT Group (ASX:GPT) was the worst performer, delivering a total return of 9.3%* through 2019, underperforming the index by 10.3%.
Matt Coleman (MC), Senior Investment Analyst, Real Estate Securities
LaSalle Logiport was one of the strongest performing JREITs, returning 52.0%* for the year whilst Mitsui Fudosan Logistics Park REIT returned 55.6%* over the same period continuing the strong performing industrial theme.
Retail remains a challenge though, although some JREITs delivered dividend per unit (DPU) growth through asset replacements. The October increase in the Japanese consumption tax from 8 to 10% isn’t helping, although most retail REITs expect this to normalise, as we saw with the previous increase.
After a poor period, the hotel market is delivering some interesting opportunities. Since 2013, there has been a big rise in inbound tourist numbers. This year, 35m+ people are expected to visit Japan, driven by the return of South Korean tourists and the Tokyo Olympic Games with the outlook beyond this event looking positive.
2. What were your most salient general observations over the past year?
PM: Last year, the divergence in sentiment towards different kinds of retail assets became quite stark. As noted above, Aventus is a great example of a portfolio of well-managed assets with predictable and sustainable rents. Capital values are therefore solid and growing sustainably. Neighbourhood and convenience-type centres owned by the likes of Shopping Centres Australia (ASX:SCP) are seen in a similar light.
At the other end of the spectrum are landlords with exposure to sub-regional assets. These have performed poorly, despite often dominant assets in the portfolio. While operational pressures are growing, landlords are still achieving attractive leasing outcomes and good rents. The market, however, sees it differently. This disparity in views explains the divergence in valuations across the sector.
CN: The political and social unrest in Hong Kong persisted for much longer than we (and most others) expected. Along with the ongoing trade war, this roiled local financial markets and brought commercial real estate deals in Hong Kong to a near-standstill. While we acted early, exiting one of our Hong Kong investments most exposed to a downturn in tourism and luxury retail, other Hong Kong REITs that we do own have been impacted by the prevailing negative sentiment, albeit to a lesser extent.
MM: AREITs demonstrated a keen focus on capital management, tapping equity markets to strengthen balance sheets. Many are now well positioned for future growth. In 2019, AREITs raised a total of $5.6* billion in new equity from public markets, five times the 2018 amount and the largest sum in the past decade.
This is a sign of opportunistic and sensible management. Record-low bond yields and political uncertainty are driving demand for defensive asset classes like commercial real estate. The sector also has attractive underlying fundamentals, featuring low vacancy rates, and a positive demand/supply outlook, leading to rental growth. It’s good to see the sector take advantage of these factors, raising capital to reduce debt and enhance portfolio quality.
The shift in emphasis towards quality also dented the aspirations of supposed disruptors. The bright lights of public disclosure requirements exposed the weaknesses of the WeWork business model. As seasoned real estate market analysts suspected, WeWork was not a revolutionary technology company but a good old-fashioned office rents arbitrager. The company’s failed IPO has led to a renewed focus on profitability rather than “expansion at all costs”. We welcome WeWork back to the real world.
MC: Japan looks compelling, a beneficiary of low interest rates, a stable political environment and good property fundamentals. The demand/supply situation in office, logistics and residential leasing markets continues to be strong. As a result, there’s good internal growth and high transaction values.
That has made it more difficult for many JREITs to acquire assets at current prices, especially when competing against private money. But Japan remains an interesting hunting ground for value-orientated investors like us. Even the trade war hasn’t affected the environment too much. Whilst investors have reduced their manufacturing exposure, ecommerce is driving demand for modern logistics facilities.
3. How did the sectors you cover fare in 2019?
PM: Retail has faced headwinds over recent years. Over 2019 weak wages growth and consumer sentiment continued to struggle. Falling house prices and a national election hardly helped. The growing influence of online retail and a steady progression of retailers entering administration has made it all-but-impossible for sentiment towards the sector to improve.
With a focus on high quality assets, the AREIT Fund is somewhat insulated but AREITs positioned at the lower end of the retail quality scale will continue to struggle.
CN: In 2019, Japan and Singapore REITs were strong performers, assisted by monetary easing and falling interest rates. Capital raisings were abundant in Asia, too, and companies taking advantage of favourable conditions to grow their portfolios were rewarded by the market. There was also a handful of M&A transactions, pursuing greater scale and relevance among a global investor base.
Hong Kong REITs were clear laggards as the China-U.S. trade row and local social unrest dampened performance. Retail sales and visitor arrivals declined significantly, with little reprieve in sight. This dragged the Hong Kong economy into recession. Despite compelling valuations, we remain cautious, adding to our positions on a highly selective basis.
MM: Australian office markets continued to perform strongly through 2019 with all major markets achieving positive growth in net effective rents whilst prime assets saw falls in investment yields. Sector transaction volumes were also significant, illustrating robust investor demand.
While performance at the asset level was generally favourable, a moderation in the pace of rental growth, net absorption and market occupancy within the Sydney CBD market in particular weighed on returns. For evidence, look no further than the relative performance of the AREIT sector’s office market proxy, Dexus Property Group (ASX:DXS). It returned 14.7%* through 2019, underperforming the index by 4.9%*.
MC: There wasn’t much variation in performance across sectors with gains of 22.2%* for the Office index, 22.6%* for Residential, and 18.8%* for Retail & Logistics. With long-term interest rates at zero or less, there was robust demand for J-REITs from yield-hungry investors. Rising rents and transaction volumes produced attractive DPU growth across the J-REIT sector as a whole.
The office sector remains driven by internal growth with limited acquisition opportunities. Most A-grade office assets are tightly held, and transaction volumes remain low. Instead, managers are looking to drive growth through narrowing the rent gap and asset replacement strategies. Across Tokyo and Osaka, A-grade office vacancy has declined to around 0.5%* and solid tenant demand should continue to drive further rental growth.
Other factors buoying performance include workplace reforms by the Abe Government and demographic shifts. While the population in Japan is shrinking, there is greater workforce participation from women and the elderly. This is a positive for office space demand. Recent workplace reforms to improve working conditions have also resulted in a significant increase in flexible co-working spaces. Co-working space represents just 1%* of the Tokyo office market compared with 3%* in Manhattan and 7%* in London.
Logistics is also showing internal growth and more capital raisings are imminent as sponsor assets come online. Demand for new supply is high with vacancy rates at 2.61%* across the Greater Tokyo Area. In addition, 80%* of new supply in the current quarter is already occupied and the reservation rate of new supply in the next six months is expected to be at the same level.
Logistics REITs are focusing on external growth; those with a good pipeline from sponsors will benefit most. For those without this pipeline support, the ability to acquire accretively could quickly unravel. A number of JREITs are also taking ROFRs1 on development assets (taking up leasing risk before asset stabilisation) to generate value.
4. What’s your outlook for the year ahead?
PM: An improving residential market, tax refunds and further interest rate cuts should provide some stimulus to the retail sector in 2020. Improving household balance sheets provide additional non-discretionary spending capacity. That should flow through to the retail sector at some stage, although it may be further delayed by bushfire impacts. With sentiment firmly against the retail sector the year ahead may be another tough one especially with the added pressures from the bush fires and the Coronavirus. What income investors need to remember is that they are being handsomely rewarded with an average retail REIT yield of almost 6%* while they await an improvement. There is no opportunity without fear.
CN: It appears the demand for reliable yield is far from sated. Last year, APN’s Asian REIT Fund delivered a total return of 23.9%2. Whilst a similar performance can’t be banked upon this year, the fund is well positioned. Across the property types, supply and demand fundamentals are mostly in check. Our favoured sectors are Singapore and Japan industrial REITs, which should benefit from improved trade outcomes and growing demand from logistics users.
MM: Indications are that office market fundamentals in Sydney, the AREIT Fund’s largest market exposure, are moderating from peak levels. While the pace of rental growth in this market is likely to slow (and vacancy rates are showing some signs of increasing), our focus is on evaluating how well office AREITs are taking advantage of the under-renting in their portfolios. If they address that smartly, earnings growth in the year ahead should be favourable.
As for the outlook for supply in the office sector, it’s elevated but not to the extent where we believe it will lead to a deterioration in rents or occupancy. We also anticipate ongoing favourable conditions for portfolio valuation growth due recent transaction activity and investor demand.
In the AREIT sector as a whole, there’s good potential for further interest rate cuts. In fact, markets are anticipating them – the 10-year government bond rate remains close to record lows. It seems the ‘lower for longer’ interest rate scenario is taking hold, as we have long believed it would. That bodes well for the relatively resilient, defensive income characteristics of AREITs.
MC: With strong fundamentals and ultra-low rates, J-REITs should continue to perform well, building on the strong performance that began in 2018.
Assuming low long-term interest rates and stable J-REIT share prices, we expect sustained demand from domestic financial institutions and individual investors seeking income. The fundamentals are good; corporate profits are strong; rates are low; tourism is thriving; and demographic shifts are favourable. No wonder there is genuine investor demand for Japanese real estate. It’s good to see the work we did to establish our portfolio positions in the country many years ago paying off.
