Since hitting a high in early August, the S&P/ASX 200 AREIT index has since declined around 13%. The fall prompts a few questions, including the reasons for it, the impacts and what we might expect from here. Let’s deal with each of those in turn.
Over the past few years AREIT sector returns have been exceptionally strong. In the last financial year alone the sector index rose around 25% and in the past three years it’s up around 18%pa. Of course, nothing goes up in a straight line forever. It’s inevitable that after such a strong rise a sell off would occur at some stage. But there’s a little more going on than that.
Returns of this magnitude, especially in a sector known for its stability and income-driven focus, have a second order effect of reinforcing recent price rises. Exceptionally low interest rates have made it more appealing to a broader audience. In recent years, property trusts have delivered exceptional capital growth in addition to regular, stable income. This has proved a powerful combination, attracting investors not ordinarily interested in the sector.
Bond yields hit an all-time low of 1.82% on August 1, 2016 which, not coincidentally, was also the recent high of the AREIT sector index. Since then, bond yields have risen in Australia due to an uptick in US bond yields, a result of slightly stronger growth and expectations of a December rate increase in the US. That’s understandable. A change in bond yields has a direct relationship with sector value. Higher bond yields normally mean lower AREIT value.
What’s more surprising is the extent of the fall in AREIT prices which the rise in rates triggered. US bond rates have risen only slightly and there’s little expectation of this rise gathering pace. The ‘lower for longer’ position that interest rates will remain near historical lows remains generally accepted, with plenty of evidence to support it, too. Australia recently launched its first ever bond with a 30-year maturity, at a yield of 3.27% and Ireland and Belgium recently sold 100-year bonds at around 2.3%. Bond yields are unlikely to creep up to anything like the levels we have seen over the last 30 years. And yet the AREIT index has fallen 13% in a few months.
That begs the question why. I’d suggest that non-traditional investors attracted to the sector by the recent impressive capital gains got cold feet. Seeing the bond rate tick up just a little was enough to get them to hit the sell button. Recent returns have been well in excess of long term averages and, as we’ve been suggesting for a while, should revert to a more realistic 9-10%pa over a period of time (yes, there might be more volatility in the short term but we are investing with a focus for income over a medium term investment timeframe). Short term investors leaving the sector because they don’t understand this point is no bad thing.
What, then, of the future? Each sector component is in reasonable shape. The better quality retail property that features in the AREIT sector is structurally sound with high barriers to entry and low vacancy rates of around 1%. Commercial office is particularly strong, especially in Sydney. Industrial is more volatile but will benefit from GDP growth and, while residential has pockets of oversupply, as a small percentage of the sector it’s not a huge risk.
Nor are valuations stretched. Although net tangible assets show a high premium to price this is an inappropriate measure as it doesn’t account for the distorting impact corporate earnings has on share prices. Net asset value and discounted cashflow valuations are more useful, reliable measures, and they suggest the sector is currently trading below fair value. The message is not to be distracted by the price falls in the sector and concentrate on accurate measures of value. This measure also does not really account for the fact that the majority of REITs which have sold assets recently have done so at healthy premiums to their book values (which is essentially their net asset values).
The economic environment isn’t bad, either. GDP growth, at 3.3% p.a. is relatively healthy and unemployment remains low. Meanwhile, the spread between the 10-year bond rate and the AREIT sector’s overall yield implies significant room for bond yields to move and for value in AREITs to be maintained. We have expected for the last 12 months (at least), gradual reversion to normalised returns of 9-10% a year. But against the current backdrop long term returns of that magnitude are nothing to be sniffed at.
Even if interest rates do edge up a little, prompting further price falls in the sector, it’s important to realise this would be a positive indicator of the health of the overall economy. Over the long term, stronger growth would impact the sector positively, delivering upwards pressure on rents, which would support greater dividend growth and capital values.
The sector’s recent fall may be bad news for investors attracted by the flashing lights of recent strong capital growth. But for genuine long term income investors the recent tumble means they can now get a reliable 6.2%1 yield from APN’s AREIT Fund compared to the 5.7%2 on offer just a few months ago.
Whilst the volatility of the APN AREIT Fund is consistently lower than that of the market and our peers, we do expect more of it. But as an income focussed, low risk fund manager we remain very confident in maintaining the all-important yield of the fund, currently 6.2%1. For investors concentrating on that and expecting modest capital growth rather than the excessively high returns of the last few years, the recent price fall is nothing to worry about. And for new investors, which can now get an attractive yield at a cheaper price, it’s to be welcomed.