Australian Real Estate Investment Trusts (A-REITs) listed on the ASX entered the August 2015 reporting season with a black cloud hanging over the global financial markets. By month end, both the markets and the A-REIT sector had been on a roller coaster ride. Speculation around whether the Fed hiked rates in September was quickly overshadowed, firstly by the Chinese currency devaluation and then by fears that China’s economic growth was faltering. As we progressed through August, the heavens opened and markets across the globe capitulated.
A-REIT Performance
The A-REIT sector held up quite well and offered a relative safe haven amongst the market turmoil. Taking the global comparison first, in local currency terms Australian A-REITs outperformed the global REIT index by 180bps (-4.1% vs -5.9%) and performed better than the US and the major Asian REIT markets (Table 1). On both a year to date and one year basis, Australian A-REITs have also held up remarkably well compared to their global counterparts.
Table 1: Total Returns – Listed Real Estate (local currency): 31 August
Source: DataStream, FTSE EPRA/NAREIT. Data as at close prices 31 August 2015
Turning to the domestic comparison relative to equities, the A-REIT’s outperformed equities by 360 bps in August (-4.1% vs -7.7%), and over one year have outperformed equities by a massive 1740 bps (14.2% vs -3.2%). Figure 1 shows there were few places to hide with the energy, banks and technology sectors particularly hard hit. A-REITs held up quite well proving their safe haven status in times of market volatility.
Figure 1: Total Returns – S&P/ASX300 Sectors: 31 August 2015
Source: Bloomberg
The small cap A-REITs, GPT Metro Property (+4.4%), GDI Property (+ 2.8%) and Australian Industrial REIT (+2.2), and the two retail stocks, Westfield (-1.1%) and SCentre (-1.2%), were the best performers. At the other end, Cromwell (-8.1%), Stockland (-8.0%) and SCA Retail (-7.9%) were the worst performers during August.
Despite posting two of the best results, the larger A-REITs in Stockland and Mirvac (-7.4%) underperformed as investors focused on the growing headwinds in the residential sector – APRA investor lending controls, deteriorating affordability levels and Mirvac CEO’s frank assessment of where we are in residential cycle:
“Previous cycles would suggest that activity, i.e., volume of sales, should moderate over the next year or two by 15%. Importantly, we don’t believe this will lead to price falls, but rather we expect price growth to moderate away from the high double-digit growth rate that it’s been experiencing in recent years.”
In terms of the reporting season, as far as the A-REITs results go, it wasn’t too bad. Across the board there weren’t many disappointments unlike the broader equities market where a number of high profile companies (Ansell, Seven, UGL, Computershare, Myer) either missed their numbers or provided bleak outlook statements and were punished by the market.
A positive for the sector was the move by many of the A-REITs to follow the Property Council’s Guidelines for Reporting and adopt Funds from Operations (FFO) to more closely align the underlying cashflow generated by the business with reported earnings. It has long been a frustration that there were so many inconsistencies across AREITs particularly in relation to their treatment of tenant incentives (which for the office A-REITs remain elevated), trading profits and lost rent on developments to name a few.
Dividends and Revaluations Positive
In an environment where investors are focused on sustainable earnings and income, the A-REIT sector’s dividend remains sound. As Figure 2 shows the dividend yield is cash covered, even after adjusting for cash received from trading activities which are typically one-offs.
Figure 2: Reconciliation Between NPAT and Dividend Paid – FY15 ($Abn)
As Morgan Stanley’s Research team point out the A-REIT sector “currently retains enough capital to fund ongoing capex requirements – despite an increase in the number of stocks supporting dividends via non-recurring profits (eg, trading profits) Bottom line…FFO/DPS growth is likely to remain smooth and sustainable for the majority of AREITs as the debt cost lever is likely to offset cyclical weakness in operating conditions or the y-on-y impact from trading profits.”
At the asset level, retail and industrial assets performed well with specialty retail sales growth stronger than it has been in years. Income growth from the office sector was the one negative, with rising tenant incentives offsetting FFO growth. Strong demand for real estate assets has driven cap rate compression, although there still appears to be a lag between A-REIT cap rates and recent market evidence (the Chinese sovereign wealth fund, Chinese
Investment Corporation’s $2.45bn acquisition of the Investa office portfolio on a 5% yield and Ascendas, a Singaporean REIT’s, $1.1bn acquisition of the GIC industrial on a very sharp yield of 6%). This should support further increases in the carrying value of A-REIT assets in the year ahead.
Lessons from the GFC Learnt
Capital management remains high on the agenda for both the A-REITs and investors. The GFC may have been seven years ago but fortunately memories still remain. Across the board, capital management is much better now and as a result, A-REIT’s balance sheets are in a stronger position. With record low interest rates, the A-REITs have not been tempted to increase gearing (with some exceptions such as Cromwell following its acquisition of the Valad Europe funds management platform). In fact, the A-REIT sector’s gearing fell almost 200 bps in the past year to circa 30%. At the same time, a number of the A-REITs took advantage of the yield curve to blend and extend their interest rate hedges. Lower debt costs will continue to be a key earnings driver in FY16.
Outlook
M&A activity could prove a positive catalyst for AREITs in the year ahead. Rising asset values, historically low interest rates and intense competition for assets means that A-REITs will find it increasingly difficult to grow organically. As has often been the case in this sector, M&A activity is one lever that can facilitate growth.
After the sell-off in August, the valuation of A-REITs looks more attractive. At the end of August 2015, the sector was trading on a FY15 cum-adjusted EPS/DPS yield of 6.4%/5.3% a healthy premium to 90-day bank bill rates (2.2%) and 10-year bonds (2.7%). This is above the average distribution spread of 180 bps over the past ten years. The sector was trading on a 3% discount to Net Asset Value (NAV) and a 27% premium to Net Tangible Assets (NTA). Given the number of stapled securities in the sector who have funds management and development platforms that are not captured in the NTA, the relevance of NTA as a measure is becoming less relevant.
A-REITs continue to provide some of the highest yields amongst the global REITs and remain attractive to investors seeking income. The recent market volatility and fall in global government bond yields should further support the search for yield. We believe this, and the dollar around 70c, should underpin demand for A-REITs in FY16.
Stock selection as always remains key. Quality management and portfolios, together with conservative balance sheets and sustainable earnings growth are fundamental to picking winners in the A-REIT sector.
