Five big questions for AREIT investors
Investing in Australian real estate investment trusts (AREITs) is supposed to be boring. The aim is to receive stable distributions that turn up like clockwork, with low share price volatility to match the predictable returns.
Over the past two years the sector has delivered on that commitment, and a whole lot more. While the S&P/ASX All Ordinaries index is below the level of June 2014, the S&P/ASX 200 AREIT index has risen by more than a third. For investors in the sector and those attracted by the yields it offers, that prompts some key questions.
What’s behind the recent price rise?
We believe interest rates are the key issue. The ‘lower for longer’ argument refers to the expectation that global growth and inflation will be low for an extended period. Indeed, the emerging theme in financial markets is ‘even lower for even longer’.
That’s having a big impact on long-term bond yields, which have hit record lows. Not only is this reducing the borrowing costs of the sector, it’s driving interest in AREITs. With global interest rates heading towards zero and in some cases going negative, investors seem more willing to pay up for yield.
With term deposits and Australian government bonds paying 2-3 per cent, the AREIT sector’s average current yield of 4.50 per cent is comparatively attractive. We believe there are few places where you can find a yield of this quality and number. That’s what’s making the sector so attractive.
Can the rally continue?
If interest rates continue to fall, yes, it’s very possible. We expect the ‘lower for longer’ theme to play out for some years yet. This would be good news as lower rates are likely to equal further price rises.
Why? Because, depending on which valuation tool you use, valuations are not yet stretched. Net Tangible Assets (NTA), a measure which many analysts prefer, indicates valuations areexpensive. But we believe this is a distorted figure due to the impact of stocks like Goodman Group (ASX: GMG) and Westfield Corporation (ASX: WFD), which include significant amounts of corporation earnings – those delivered by property development activities rather than rents. These stocks trade at significant premiums to NTA (as much as 70 per cent to 100 per cent) and represent around 26 per cent of the AREIT sector, distorting the overall market premium to NTA. There are still a number of AREITs that trade below NTA.
Moreover, AREITs are liquid assets and are not liable for stamp duty and legal expenses, which can be as much as six per cent of an asset’s value. A ‘neutral’ 10-15 per cent premium to NTA isn’t unreasonable. Exclude Goodman Group and Westfield Corporation and the sector’s premium to NTA is 24 per cent.
Although common, NTA is far from a perfect tool to value stocks. Many AREITs are structured with securities in a trust and a company ‘stapled’ together. Both parts should be valued separately. The Net Asset Value (NAV) does that. It indicates the sector is trading around fair value. Further, future growth in rents and asset values should deliver further increases in NTA.
And if you believe that interest rates will stay low for an extended period, then there may be value in the sector.
All things considered, the recent surge in AREIT share prices seems to have a foundation and we believe the fundamentals remain attractive.
Is the AREIT market reminiscent of the pre-GFC period?
Definitely not. Debt is now lower and better managed, with a greater diversity and longer tenure. The earnings that AREITs produce are driven by rents rather than ‘corporate’ earnings, where previously the sector chased over-priced assets. Overseas earnings are significantly lower and management teams more realistic and sensible.
We believe the key risks that were substantially responsible for the magnified impact of the GFC on the AREIT sector are now far lower than in 2006-7. The sector has returned to its roots and is all the better for it.
Which parts of the sector have the best prospects?
We believe there’s long term value in retail property. High barriers to entry typify much of the sector we’re invested in. Investments in super regional shopping centres like Chadstone and Bondi Junction are likely to perform strongly. Well-located and managed assets catering to daily shopping needs may also provide a steady earnings stream. Office portfolios exposed to the strong Sydney and Melbourne markets should also deliver growth in earnings.
But you’re better off in a diversified, balanced portfolio of AREITs than trying to pick individual winners. Diversification is just as important in this sector as any other.
What are the key themes to watch next financial year?
The theme of ‘lower for longer’ is likely to dominate. We agree with the Reserve Bank of Australia that inflation will trend lower and that GDP growth will not be above the long term trend. We expect income investments to remain popular as a result.
If asset values continue to rise, debt, as a proportion of gross assets, should fall for most AREITs, allowing them to borrow more (at low interest rates) to acquire more assets. Correspondingly, we expect growth in AREIT portfolios should deliver higher earnings and greater diversity.