[Editor’s Note: Do not read the following commentary as a recommendation to invest in A-REITs. Like all investments, A-REITs have benefits and risks. The sector can potentially underperform the broader Australian sharemarket during periods of high interest rates. If a recession occurs, values for office, retail and other property types could fall further. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article.]
 

Last time we checked, Melbourne Central, Westfield Bondi Junction, and Governor Phillip Tower in Sydney’s CBD were not for sale, but you can own a share of these properties through Australian Real Estate Investment Trusts (A-REITs) on ASX.

What A-REITs are

A-REITs pool the monies of multiple investors, creating a more diversified property portfolio than an investor can achieve on their own. A-REITs also hold properties that are otherwise unavailable and they are more liquid than direct property [their units can be bought and sold via ASX].

Characteristics of A-REITs

Listed A-REITs have similarities to companies and can be traded on the ASX via a broker. Investors can use similar valuation techniques – dividend yield and price/earnings ratio being simplistic examples – and more involved techniques including Morningstar’s three-stage discounted cashflow models that we use to value A-REITs, as we do for companies that we analyse.

A-REITs regularly publish their net tangible assets, or NTA. The NTA incorporates tangible assets such as land and buildings and deducts liabilities such as debt. 

Examining whether an A-REIT is trading at a premium or discount to NTA can be informative. It’s worth noting that the NTA relies on the opinion of property appraisers, so while it’s a useful indicator, the NTA may be a barometer of current conditions, and is not always a reliable estimate of intrinsic value.

Another key difference from listed companies is that A-REITs don’t pay tax on the rental portion of their income. The yields are higher than they otherwise would be but may not have franking credits. The objective of these rules is to make A-REIT ownership akin to owning property directly, with the added convenience and liquidity of a listed investment.

How A-REITs differ from direct property

Even if a trophy property is for sale, it might cost billions of dollars, could take months to buy or sell (with a team of lawyers), and transaction costs could be large. 

In comparison to buying into such a property, investors can buy into listed A-REITs. These A-REITs can be bought or sold online at the click of a button. Transaction costs (brokerage) and indirect costs (the buy/sell spread on the A-REIT) are typically fractions of a percent.

Unlike direct property, investing in A-REITs doesn’t require property management effort because A-REITs have a professional management team, either internal or external (for the record, Morningstar prefers internal management as it reduces conflicts of interest, but there are some well run, externally managed A-REITs). For these reasons real estate investment trusts, or A-REITs, are a popular way to invest in commercial property.

What drives A-REIT performance

Long-term returns from A-REITs depend on how the underlying properties perform, good or bad. However, there are key differences between how performance is generated between direct property and A-REITs. 

Firstly, management can add or destroy value, and the second big one is gearing, which amplifies the upside and downside risks. The classic example of how this played out for A-REITs was in the 2008 Global Financial Crisis (GFC). Some management teams loaded A-REITs with too much short-dated debt. Unable to roll over maturing obligations, many A-REITs were forced into dilutive equity raising, decimating shareholder value. 

Pockets of commercial property in the United States now face similar problems, but arguably, Australian management teams learned some lessons. Most A-REITs now have manageable gearing levels in Morningstar’s opinion, and have locked in long-term debt with staggered maturities, reducing the risk of a large portion of debt coming due at a time of market stress.

Why A-REITs are sensitive to interest rates

Despite being more conservatively managed now (in Morningstar’s opinion), A-REITs remain interest-rate-sensitive for three main reasons. 

First, so-called defensive sectors such as A-REITs, listed infrastructure, and utilities, with their earnings driven by long-dated contracts, still have heavy debt loads compared to other sectors. Debt amplifies returns (and risks), and the more secure the earnings, the more debt a company can carry. Higher interest rates increase the cost of debt, which impacts the A-REIT sector.

Second, high interest rates drag down economic activity, which weighs on A-REIT revenues such as the rents on offices, retail shops and industrial sheds.

Third is the question of how much the market will pay for a stream of earnings. The earnings multiple, or the price/earnings (P/E) ratio is one measure of this. Many A-REITs trade on high multiples (high P/E ratio), partly because the earnings are more predictable than other sectors. Revenues are contracted under the lease agreements that A-REITs sign with tenants, often with fixed annual uplifts (to rents).

As interest rates rise, highly valued long-dated earnings become comparatively less attractive due to higher discount rates, and other options become more attractive, such as high interest savings accounts or bonds.

What higher interest rates mean for the A-REIT sector

Rising interest rates are a major headwind for A-REITs. But in the long run, A-REIT earnings are driven by per-capita economic growth and population growth. Solid economic growth over time should buoy conditions for the retail, corporate and industrial tenants that occupy malls, offices and warehouses, in Morningstar’s opinion.

Even inflation is not uniformly bad if it’s at moderate levels. A-REITs with leases linked to inflation are able to increase rents in line with, or even above inflation. And some industrial A-REITs are currently seeing strong rental growth as businesses strive to solve the very supply chain challenges that contributed to inflation and high interest rates.

A-REIT risks

But to get to the long run, one must survive the short run. Morningstar treats with caution any A-REIT with very high debt, or substantial near-term maturities, as they may be forced to raise equity or sell assets at distressed prices. 

A-REIT balance sheets look more solid than prior to the GFC, management having learned prior lessons. But some names still look vulnerable, in Morningstar’s opinion. If interest rates go substantially higher than the market expects, the sector could suffer more pain. 

It’s also worth noting that just like any other sector, A-REITs face structural threats and opportunities from new technology, changing social norms, and shifting geopolitical priorities. The growth of hybrid working, AI, and ecommerce are a few examples.

A full exploration of the investment outlook for A-REITs is beyond the scope of this article but research on the Morningstar website delves into the A-REIT sub-sectors and stocks, and analyses which stocks we view as overvalued and undervalued, and why.