We recognise just how much commentary is available these days.
APN continues to believe commercial property is an outstanding investment which is under-represented in many investors’ portfolios. AREITs own some of Australia’s best quality commercial properties which generate strong and consistent rental income with modest levels of debt. For long term investors looking for sustainable income we continue to believe our ‘property for income’ approach will serve you well.
Here are the top six questions financial advisers are asking us right now.
1. Why is the APN AREIT Fund underperforming the index?
As many of our long term investors know, we are index unaware. We recommend investing in our fund for five years or more and this reflects our focus on reliable rental income.
We accept that at times this will mean that we generate lower total returns than the index, but this does not change our income focus. However, we know that regardless, some investors will compare our performance against the index. The reason for APN’s underperformance is twofold. First, the APN AREIT Fund is underweight Goodman Group and Charter Hall. In the year to the end of April, these stocks have risen 15.5% and 9.7% respectively. Strange as it may seem, we’re prepared to miss out on these gains. Both have significant earnings risk (through development and funds management businesses), which adds considerable risk to the portfolio. With a focus on steady, reliable income over the long term, our mandate sensibly restricts us from over-exposure to stocks like these.
Secondly, there’s a lot of fear in the retail sector, especially around the arrival of Amazon and online spending. This has hurt the performance of Scentre Group and Vicinity Centres, Australia’s two largest shopping centre owners, both of which form a cornerstone of APN’s AREIT Fund.
It’s all but impossible for an active manager to experience uninterrupted periods of beating the Index over the short term. In fact, as counter-intuitive as it may sound, it is the periods of underperformance that deliver the opportunities that lead to long term outperformance.
Far be it for us to suggest that we have the same track record of investing as Warren Buffet but Buffet and a group of other long term outperforming managers analysed by Morningstar were found to underperform 65% of the time – the other 35% they did particularly well, to deliver their overall record.
We believe the recent period will prove to be a future case in point. For reasons explained in Shopping smart: Index investors push Scentre into bargain bin and Property trusts: What could go wrong (The Amazon threat), we think the Amazon threat is overstated. The effect has been to push down the share prices of Scentre and Vicinity to the point where we have been happy buyers. The underperformance of these stocks sets us up for attractive future returns. The immediate price is short term underperformance of the APN AREIT Fund. Which is to say that the pain is also the opportunity.
Of course, this doesn’t make it easy for investors. It’s unnerving for many to see the APN AREIT Fund’s total returns deliver less than the index (despite the regular distribution payments rolling in!). But it’s vital to also understand that this is an important time in the cycle, setting us up for future long term outperformance. And we have the track record to back up our approach.
Since inception in January 2009, the APN AREIT Fund has delivered a total return of 13.91%1 to 30 April 2018, after all fees and expenses, compared with 11.8%2 of the AREIT Index over the same period.
It can be tempting to change tack during volatile times. With more than 22 years of investing experience, however, we’ve seen the self-inflicted damage others have experienced from deviating from their core investment strategy.
APN does not intend to make that mistake. Concentrating on AREIT stocks that deliver the highest levels of sustainable income along with lower risk than the market is central to our investment approach. If that means periods of underperformance that allow us to get set for better long term returns, so be it. We trust that our investors and advisors appreciate the value in this long term approach.
2. What does the future of retail look like considering the challenge of online shopping and Amazon’s entry to Australia?
US Department store closures, sluggish retail sales, weak wages growth, the demise of local brands and the arrival of Amazon have culminated in the perfect retail storm.
We’re not deniers of Amazon or the fierce pressure that retailers are facing. There will be winners and losers in the dynamically changing retail world.
The winners will be the fortress-like shopping centres that are investing billions as they transform into ‘experiential’ environments which is generating more foot traffic and, ultimately, higher retailer demand for superior quality real estate. Innovative offerings geared towards enhancing and simplifying the in-store experience are rapidly increasing. Whether its deploying smart technology, running makeup tutorials, offering free coding classes, replacing tired food courts with trendy restaurants and lifestyle destinations – the examples are many.
The remixing process is well advanced in Australia as REITs are moving away from department stores and fashion and doubling down on food, wellness and leisure categories. As department stores shrink, the additional space is being taken up by mini majors and specialty stores who pay 3-4 times more rent per square metre than the likes of David Jones and Myer.
There isn’t much evidence of shopping malls dying: at least at the top end they’re well and truly alive. At less than 1%, vacancy rates are at record lows and global brands are lining up to take space in these centres. Rents are rising and centre owners are reinvesting billions on extensions and upgrades.
The fear of the death of conventional retailing is largely being driven by the US experience; parallels which are badly drawn. The US has more than twice the retail floor space per capita, almost twice the department store space per capita and more than ten times the vacancy rate of the best malls in Australia. Australia leads the world in the quality of its shopping centres; the US lags it.
And as for the concerns around digital retailing, it’s a myth that online sales are growing at fever pitch. Over the 12 months to the end of March 2018, it’s estimated that Australians spent around $25.3 billion on online retail – this is equivalent to 8.1% of traditional bricks and mortar sales3. The rate of growth in online sales however, is slowing. And it’s interesting to note that two of the largest contributors to the annual growth spend are media (26.6%) and online food delivery (10.1%) – categories which largely don’t compete at all (media) or who typically don’t compete with traditional retailers in the shopping centres we invest in (food).
If a centre cannot deliver an attractive, innovative experience, then it must be perfectly convenient; a place where shoppers go for their regular spend on everyday items because it’s either close or there’s no other choice. We’ll be focussing on the high quality “experience or convenience” assets and steering clear of secondary assets.
One of the key reasons why we like high quality shopping centres is their high barriers to entry – from town planning to capital and management complexity. Often people can forget that the location and the land on which these centres are built are critical long term value drivers. underpinned by strong catchment areas (lots of people) their reinvention into some other form of commercial real estate (be it retail, residential or offices) goes a long way to underpinning the value of these investments. The recent sale of a car park of Flinders St in Melbourne is a good example of this – a sale price of over $90 million was achieved (double its book value) as a future residential development given the quality of its location.
3. How can REITs continue to increase rents when retailers are complaining they’re already too high?
In the better shopping centres (which are the ones typically owned in AREIT portfolios) it’s a question of supply and demand. For every local retailer complaining about high rents, there’s an international or upcoming local chain ready to take their place. Occupancy costs remain reasonable (and in line with long term averages), vacancy rates are low (at less than 1%) and debtor rates are minimal – all are important metrics which support a strong case for sustained rental income. Of course, the demand and supply equation is very different in assets that are lower down the “quality chain”. High Street shops for example are being decimated by online retail. Happily, we will never be exposed to these markets in the APN AREIT Fund.
Approximately 35% of speciality retailers in Westfield centres four years ago no longer exist today. This is an important statistic. Despite the concerns of retailers folding, tenant turnover has been a common long-term trend and does not necessarily spell trouble for retailers. In fact landlords may welcome the change as they replace poor performing brands with new ones (who are often willing to pay a higher rate of rent). The retail landscape is dynamic with consumer trends forever changing. Retailers are attracted by our growing and wealthy population and lethargic competitive environment. Retailers that haven’t responded to the online threat and have grown fat on high margins, or those that compete primarily on price, are ripe for the picking.
Good retail centre managers know this. They may have an incentive to push retail rents as far as possible but not to the point of overburdening the tenant. Generally, rent negotiations strike a balance between what can be afforded by the tenant and what a similar tenant should be able to afford (the market rent).
4. Can Retail REITs maintain their current distributions?
Yes. We believe retail assets in key AREITs will continue to produce attractive, consistent, lower risk income in the short, medium and long term. With retailers queueing up to get into Australia’s best shopping centres and supply limited, we expect rents to increase over time.
The latest half year reporting season results provided more evidence in support of sustainable distributions with Retail REITs delivering net property income growth of 2.3% for the calendar year ending December 2017.
5. Are AREIT assets over-valued?
We don’t think so. In fact, there’s plenty of sales evidence that indicates AREIT asset values are more likely to increase than fall.
Retail malls saw cap rate falls of 24bps in this half year period alone. Scentre Group experienced 35bps falls to 4.91% and Vicinity 30bps to 5.45%. That may not sound significant but it contributed an additional $2.7 billion in upwards asset revaluations. Why? Because as cap rates fall, valuations rise. This re-affirms our view that, largely due to a lack of transaction evidence, the country’s highest quality, fortress-malls remain undervalued.
Both the office and industrial segments of AREIT portfolios also enjoyed valuation increases through the half year reporting period, led by cap rates falling 17bps and 21bps respectively. The evidence suggests asset valuation increases are justified and may continue. And even more recently, sales evidence is reflecting prices that are higher than valuations/book value.
If AREITs were valued in the same way as direct investment in commercial property, unit prices would probably be higher. That doesn’t mean that gap will close but it does suggest AREIT investors can take additional comfort in the security of their distributions. It also suggests income-focussed investors can secure an attractive yield at an attractive price.
6. What about the threat of rising interest and US bond rates?
Rising interest rates can be good for the AREIT sector.
It’s true that as interest rates rise, all else being equal, debt costs rise and the value of an asset’s future income stream falls. But when interest rates are rising, they’re usually an indicator of buoyant economic conditions, a mark of low unemployment and inflation and high business and consumer confidence.
In such environments, businesses expand, leading to increasing demand for office and retail space and logistics facilities. This higher demand for space is a by-product of elevated economic activity. Eventually, rents rise – driving long-term value for commercial real estate investors.
It may challenge conventional wisdom but this explains the mechanisms by which rate rises can be good for AREIT returns. And the data supports the argument. In the last five interest rate tightening cycles (an aggregate 100 months) the S&P/ASX 200 AREIT Accumulation Index achieved an average annualised total return of 7.5%. Even after excluding the longest RBA tightening cycle from 2002 to 2008 (preceding and including the GFC), the AREIT sector returned 7.0%.
When interest rates rise, the sector is well positioned to deal with it. The average AREIT debt term is 5.3 years. That means, on average, only 20% of the debt is refinanced each year. The sector is also less reliant on debt; average gearing is now 28.2%, and over 60% of that is fixed cost debt. So when rates increase, they won’t hit a property trust’s cost base in the way they did a decade ago. AREITs have positioned themselves to minimise the impact of higher interest rates on the bottom line.