This year’s dog can often be next year’s star for investors. The second worst sector so far in calendar 2022 belongs to REIT’s, second only to the tech sector.
Hugh Dive the Chief Investment Officer at Atlas Funds Management says there are two reasons for the REIT sell off. Firstly the whole sector has been derated. The REIT index was trading on a price earnings multiple of 21 times in January 2022 and is currently trading on a multiple of 14.9. Secondly, interest rates have risen for the first time in a decade with the 10 year bond rate up by around 150% so far in 2022. REIT’s are viewed as an interest rate sensitive sector.
Pete Morrissey the Head of Real Estate Securities at Dexus Asset Management highlights that the REIT’s with higher gearing, aggressive cap rates and lower levels of interest rate hedging suffered the most along with those with funds management businesses contributing to their earnings.
Higher interest rates are negative for the REIT sector as they increase the discount rate (referred to the cap rate) used to value the expected cash flows from owning property which reduces the asset value. Higher rates can also increase the interest costs for REIT’s so if rents do not keep pace with interest costs, income distributions can decline.
Cap rates are a measure that helps evaluate real estate investment and a higher cap rate results in a lower property value, so the higher the cap rate, the better it is for the investor.
Each REIT uses its own cap rate to determine its valuation. A comparison of two industrial trusts, Centuria Industrial REIT (CIP), and Dexus Industria REIT (DXI) shows that CIP uses a cap rate of 4.19%, while DXI is using a far more conservative cap rate of 5.04% to determine valuation. This means that investors need to consider the merits of the individual trusts as not all REIT’s are equal.
Dive believes that while cap rates will expand, there are still transactions in the physical markets being settled in the 4% range for industrial and office property, and 5% for supermarkets, so the pressure to revalue assets downward isn’t intense.
Dive says the broad based sell off in REIT’s in August and September saw most trusts fall 17%, with little consideration for the differences in underlying tenants, lease escalators, debt costs or debt structure.
Morrissey believes there is reason for optimism and points to many REIT’s now trading at 30% plus discounts to their June 2022 net tangible asset backing. He says that the market reaction has provided investors with the opportunity to invest in REIT’s at deeply discounted values while collecting income yields averaging around 6%.
Morrissey prefers REIT’s with strong balance sheets and above average hedging of debt to protect their interest costs. He also likes REIT’s that offer inflation linked earnings growth in the current environment. Morrissey likes non-discretionary supermarket anchored retail REIT’s due to earnings predictability, tenant covenant quality and longer lease terms.
Supermarket landlord Shopping Centres Australia has an average term of its debt of 5.5 years and is 80% hedged with rents linked to CPI. It will see a kicker in turnover rent from food inflation, and as mortgage payments rise we may see budget conscious consumers limit restaurant visits in favour of cooking at home.
In addition to non discretionary retail, Dive also likes the Industrial, Educational and Medical sectors.
Morrissey remains cautious on the office sector due to the high level of uncertainty created by working from home. He adds that Office REIT’s are some of the cheapest going around and it is clear that quality office buildings remain in demand for many businesses as culture can only be built in the office. Dive is limiting exposure to REIT’s with earnings from property development due to the volatility of their earnings. He is also cautious on discretionary retail REIT’s.
The REIT sector in general is far better equipped to handle rising rates in 2022 than it was in 2007, when many trusts used the short term wholesale market to fund their debt. On average, in October 2022, the REIT sector has a gearing level around 20% with debt maturity of 5.1 years. While some REIT’s may struggle with a slowing economy and higher debt costs, other trusts are likely to see minimal or even positive impacts from changing economic conditions resulting in a stable and growing income stream. Among the price destruction of 2022, the REIT sector is likely to present investors with some good opportunity.
This article featured in the Australian Financial Review on Wednesday 2nd November 2022. Mark Draper writes monthly for the AFR.
** Mark Draper owns shares in Shopping Centres Australia and Dexus Industria REIT