For obvious reasons, this AREIT reporting season was unlike any other. The impact of COVID-19 on the sector is reflected in the S&P/ASX 300 AREIT Index returning -20.7% over the last financial year versus the broader S&P/ASX 300 Equities Index which returned -7.6%.

As noted in AREIT reporting season wrap Q&A, we expected an elevated level of complexity and cautious outlooks. Needless to say, both those expectations were met. Before diving into the sector-specific commentary, here are seven insights that have framed our portfolio investment decisions in this unique environment.

1.  Cash collection is king

Pandemic-stricken AREITs experienced a heavy impact to their top-line earnings. For the last quarter of the last financial year (FY20), cash rent collection averaged just 78%. This was down to the collision of lockdown restrictions and government policy that allowed tenants in difficulty to reduce rental payments. The situation was further exacerbated by some tenants with the capacity to pay refusing to do so.

As the chart below shows, the retail sector was hardest hit, achieving just over half the cash rents of what would ordinarily have been collected. Despite most shopping centres remaining open, many stores were forced to close. In contrast, across the Industrial sector rent collections were at pre-pandemic levels while Office suffered slightly more.

AREIT Cash Rent Collection – June Quarter 2020

Source: APN, Macquarie

With a decades-long focus on property for income, we’re well aware that the cash collected from tenants is king. Without it, the monthly distributions on which our investors rely is at risk. That focus caused us to reduce our discretionary retail exposure early in the pandemic, a move that now seems wise.

Since the June quarter, rent collection has improved substantially. Things aren’t yet normal but they’re heading in that direction. In the meantime, cash collection remains jack, queen and king. If you’re going to follow any AREIT sector metric, this is it.

2.  Don’t sweat the debt

While relative yield in AREITs is high, gearing across the sector – currently 27% – is lower than the historical average of around 30%. In fact, gearing levels have generally improved over the last six months, leaving the larger, diversified AREITs very prudently geared.

The structure of the debt is also generally more diverse, with improved tenure and hedging than in the past. As the table below shows, lower rates have also improved debt servicing ratios. As higher priced debt facilities expire, they are being replaced by those costing less. This is a tailwind that should continue.

The market has been anticipating that more AREITs will raise capital to reduce debt, but these are stock-specific rather than sector-wide concerns. If the outlook for cash collection and asset values deteriorates, asset sales and/or equity might be required. That’s possible but not probable in our view.

Source: APN, JP Morgan, Macquarie
*NPI Growth excludes Retail Mall landlords which did not report this matric to June 2020

3.  There’s opportunity in the uncertainty

Most AREITs were unable to give earnings and distribution guidance for the coming year. That’s understandable – everything depends on the virus. Where earnings or distribution guidance wasn’t offered, most AREITs (81% by market capitalisation) committed to some form of direction on earnings, distributions or payout of operating cash flow in FY21. This compares favourably with Industrials (64%) and Financials (13.2%), two more sectors where investors appreciate earnings certainty.

Of course, the future is always uncertain; nowadays it’s more so. In a reporting sense the AREIT sector has performed well. If and when lockdown restrictions end, AREIT managers are likely to be more confident in their forecasts and outlooks. Until then, we should learn to live with the uncertainty and think about profiting from its silver lining.

With rates falling to historic lows, it’s been tough going for income investors for years. But right now, the AREIT sector distribution yield, relative to the 10-year bond yield, is well above historical averages. This general point is well made in the specific. The APN AREIT Fund, for example, currently enjoys a running yield of 6.36% pa¹. The uncertainty in the sector is an opportunity for those prepared to buy selectively.

Source: APN, JP Morgan

4.  Not all retail is created equal

Mall landlords were hit much harder than those catering to everyday needs shoppers, large-format goods and non-discretionary segments. The retail sector disappointed in every way we thought it would. Shopping centre portfolios showed the lowest levels of cash rent collection, the largest increases in vacancies and the biggest declines in asset values. As a result, landlords have been forced to make large provisions for rent that is owed but as yet unpaid.

The impact of lockdowns and social distancing on major mall landlords like Scentre Group and Vicinity Centres was enormous. Shopper footfall and tenant sales all but disappeared, provoking $580m in rent waivers or rent provisions provided by the major retail landlords.

In contrast, the ebullience of large format retail was impressive. Aventus, an AREIT specialising in large format retail in which we have an over-weight position, owns a property portfolio inadvertently made for pandemics.

Its tenants deal in home improvement, office supplies and electronics. These retail businesses remained open and popular, and for those not willing to enter, click and collect was introduced. Amongst its retail peers, cash rent collection was the highest, with minimal deferrals and abatements.

The situation since the end of June has moved on. Early indications are that, outside of Victoria, month-on-month sales data is improving. In July, sales growth was recorded, along with higher store openings, visitations and cash collections.

In summary, non-discretionary retail is doing far better than discretionary; the leasing code of conduct will end, as will the pandemic; and when it does footfall is likely to return everywhere, just as it did after the first lockdown.

5.  Not dying but changing; the future of the office

In the Office sector, there are cyclical challenges associated with a recessionary environment and depressed business confidence but also structural issues around evolving workplace practises. These will likely weigh on the sector.

AREIT results suggested valuations continue to lag the physical market and although effective rents (cash rents after any incentive) in Sydney and Melbourne held up well to June 2020, in the last two months they have come under pressure as incentives have risen. According to some agents Sydney and Melbourne are on track to record 10-12% peak vacancy rates while sub-lease space in these major CBDs is rapidly expanding. Both suggest tenant demand turning negative.

Listed portfolios with relatively high vacancy rates, fit-for-purpose spaces at an affordable price-point will likely perform better than those with near-term expiry risk and higher rental rates. At this point, our preference is for metropolitan rather than CBD portfolios.

The reasoning is best explained through a comparison. Specialised metropolitan office landlord Centuria Office REIT (COF) has maintained an occupancy rate of 98.6% through the period. Major CBD landlords like Dexus (DXS) suffered an occupancy decline to 96.5%. Revealingly, COF was also able to provide distribution guidance for FY21 whereas DXS did not.

Contrary to popular expectation, the office is not at death’s door. Many businesses value the enhanced productivity and cultural benefits of having teams physically present. The water-cooler conversation is under-valued and difficult to replace. Nor will everyone be working from home full time. And for various reasons, businesses, governments and bureaucracies need physical office space. Offices may be evolving but they will not disappear.

6.  Industrial shows its strength

Of the three major sectors, Industrial has been the top performer. Results showed that, except for minor pockets of stress among small and medium enterprises and those with business exposure to affected industries like hospitality and events, industrial portfolios were largely unaffected by the pandemic.

With vacancy rates remaining stable and like-for-like income growth continuing, the two pure-play industrial REITs – Goodman Group and Centuria Industrial REIT – both offered earnings and distribution guidance for FY21.

Goodman Group increased its work in progress to capitalise on demand from tenants in online retail, grocery distribution, logistics and data centre industries. This should lead to higher development earnings and overall portfolio quality growth in the longer term. There’s a lot of excitement around this expansion and the pandemic has shown much of it is warranted.

In contrast to retail and office, the outlook in industrial and logistics is favourable with capital and rental growth set to continue. Further growth in online retail will assist logistics while an increasing need for higher inventory levels could drive incremental demand for additional warehouse space.

The market is already aware of these dynamics. The share prices of stocks like Goodman have quickly recovered (and then some), assisted by some recent long-leased industrial assets attracting very tight cap rates. Whilst growth is generally priced in across the industrial sector, select opportunities remain.

7.  Alternative property remains resilient

Some alternative property types owned by specialist AREIT landlords delivered high-quality results similar to those in the industrial sector, including positive like-for-like income growth, NTA growth and a high level of earnings certainty for FY21. The common thread was that many were deemed ‘essential service’ providers.

AREITs specialising in the ownership and management of service stations, for example, have proved particularly defensive throughout the pandemic. Both Waypoint REIT and APN Convenience Retail REIT achieved impressive levels of June 2020 quarter rent collection. Each also offered future guidance on distributions.

AREITs specialising in social infrastructure property like early childhood education centres and medical clinics also indicated solid prospects. Arena REIT, owner of early learning and medical centres, indicated childcare developments remain an attractive opportunity with like-for-like (LFL) rent increase of 3.4% across its portfolio. In stark contrast to the retail and office sectors, its NTA increased 1.8%.

Charter Hall Social Infrastructure REIT, another owner of early learning centres, posted solid LFL income growth of 2.8%, a beneficiary of its high proportion of fixed annual rent reviews and an improved average lease term of 12.7 years

What does it all mean?

APN has always prioritised reliability and security of income. Arguably, this has never been more important. The concerns over the future of offices and shopping centres are being expressed in depressed valuations across the sector, whether these concerns are justified or not.

For income investors, this might be a worrying time but it is also one full of opportunity. In fact, the concerns are the reason for the opportunity.

AREIT valuations relative to underlying net assets imply that many AREITs are currently attractively priced. With the distribution yield relative to the 10-year bond rate well above historical average, for the first time in years value-focused income investors have something to sink their teeth into.

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.  As at 21 September 2020. 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. Past performance is not an indicator of future returns.