A good year for A-REITs expected, but increasing risks for investors.

It was an interesting 2019 for global markets and against that backdrop so too for the Australian property market and its various subsectors.

In late 2018 the US Federal Reserve moved from a more hawkish to a dovish position on interest rates and this continued into 2019. The Reserve Bank of Australia cut interest rates after the federal election and continued to be accommodative as the year progressed.

This provided a favourable backdrop for property, driven by an appetite for yield. 

For the past two years we have been at an advanced stage in the property cycle, particularly for commercial and industrial property. Capitalisation rates (rental yields) are below those in prior peaks, with the lower bond yield environment extending pricing of property assets.

From a portfolio perspective, we adopt a more conservative through-the-cycle approach in our investment analysis, to become cautious at advanced stages of the cycle and opportunistic when prices are attractive.

During 2019, there was considerable pricing dispersion across the Australian Real Estate Investment (A-REIT) sector and on our analysis this was the widest since the GFC.

The market has been ascribing a considerable premium for what are considered higher growth groups, with earnings from development and funds management in particular. 

At the other end of the spectrum, high quality and lower risk groups are trading at discounts, which provides a real opportunity for absolute returns, with less downside risk.

Characteristics of a late-stage property cycle include:

• Capitalisation rates (yields) are below levels in previous peaks.
• Capitalisation rates have converged across sectors as well as quality types.
• Strong investment flows towards industrial and office property, which will ultimately drive a supply cycle.
• The market is prepared to assign high multiples and growth expectations for higher risk and more cyclical activities, such as development and funds management. 

Interestingly, across the broader investment spectrum, including equity markets, there has been a very significant divergence between growth and value companies, and what we have been experiencing in the property sector sits within this broader context – late cycle, higher pricing and more elevated risk appetite.

Given this, our view is to position defensively by investing in high-quality assets with less cycle exposure, which at present are priced very favourably to the more cyclical or operationally leveraged groups.

Our observations for the main property subsectors include:

Office

Over many decades, offices have proved to be cyclical assets. The barriers to entry in office building are not high given site requirements and construction time extends over two to three years. 

There is a concept called the “skyscraper index” which acts as a precursor to impending recessions or financial crisis, with high-profile buildings conceived in boom times to be finished as the economy falters. While somewhat theoretical, this was experienced in the early 1990s in Australia with a supply of premium buildings completed as Australia entered recession.

Vacancy rates have been low, sitting at levels not seen since the late 1980s. Although tenant demand in recent years has been strong, the combination of these factors has fuelled rental growth. Given this backdrop, coupled with low bond yields, investment demand has been strong for office properties. 

However, as the economy has slowed, so too has tenant demand and with net absorption (take up of space) soft over the past year in Sydney and Melbourne, rental growth is moderating and a supply cycle is developing. 

Our analysis of previous cycles indicates a closer link between vacancy rates and rents with capitalisation rates than there is between bond yields and capitalisation rates. With vacancy rates set to rise and rent conditions moderating, we see less value in this subsector, both in the direct market and the AREIT sector.

Retail

The retail subsector has been out of favour over the past three years, with modest sales growth and concerns associated with online sales penetration. 

Retail landlords have been responsive in remixing centres to more experience-based offerings. The best retailers, however, have been connecting to the consumer both online and through bricks and mortar, accelerating growth and importantly, margins. 

The biggest issue for bricks-and-mortar retail sales is that the consumer is experiencing low wages growth. This appeared to have bottomed out in 2017 and is now showing modest signs of improvement. While retail sales growth is low, we are also seeing some improvement across the retail REIT portfolios.

Institutions have been motivated sellers of retail property, including within AREITs, with very high-net-wealth private groups as well as some offshore REITs being the buyers. 

There is a perception of an overhang of retail property on the market, but we have already noticed some groups more tentative with their selling ambitions and some even potentially shifting gear to pursuing acquisitions.

This subsector is attractive as historically it has been very defensive and thus a good asset class for late-cycle investing, with the added attraction that it is favourably priced within the AREIT sector. 

Top retail assets are one of the most superior forms of real estate exposure over time for several reasons, including:

1. Very high barriers to entry. They occupy large footprints of land in urban locations, with tight planning requirements.
2. Developments are typically led by demand, unlike office and industrial, which can have a speculative nature.
3. Highly diversified income base with 99 per cent-plus occupancy rate over time.
4. Significantly lower maintenance capital expenditure and lease incentives to office as an example.
5. The opportunity to develop, transform and grow the centres.
6. Top regional malls are the only property asset class that has the word fortress ascribed to them. 

Beyond the top regional malls, we also like the convenient neighbourhood centres or sub-regional centres that have a commanding position within non-metropolitan communities or the ability to expand over time. 

Residential

While credit constraints have been emerging for a number of years, the advent of the Royal Commission and tighter lending requirements had a detrimental impact on the housing market in terms of prices, volumes and settlement periods. 

In addition, the prospect of a Labor Government with a policy of abolishing negative gearing and reducing concessional capital gains tax (CGT) for the purchases of established homes, further dampened investor enthusiasm.

After the federal election, we observed:

• The status quo for negative gearing and concessional Capital Gains  Tax.
• A relaxation of the assessment rate by the Australian Prudential Regulation Authority (APRA) used to assess a borrower’s serviceability from a minimum 7 per cent to 2 per cent above the mortgage product rate.
• RBA interest rate cuts. 

These factors have collectively seen a steady improvement in both prices and volumes.

Going forward, price growth will be limited while the volume of new homes will continue to improve because of population growth. 

Industrial

Industrial has been the favoured property subsector for a number of years, driven by the rise of e-commerce and institutions being underexposed to the sector. This is more a weight of capital argument rather than a fundamental proposition; e-commerce is only part of the market and, with the exception of infill markets such as Sydney, rental growth continues to be modest.

We are attracted to industrial where there is the prospect of better opportunities for property usage, but more cautious towards large, purpose-built properties because of strong pricing.

Other sectors

Within the AREIT universe there are some other interesting subsectors, such as:

• Childcare
• Hotels
• Medical
• Rural
• Self-storage
• Service stations

The attraction of some of these is that they have the potential to re-rate as they become mainstream, while others are already keenly priced by private investors. Overall, most are less cyclical and justify some exposure.

Conclusions

It was a relatively good year for the AREIT sector, with strong returns. Looking ahead, if bond yields stay around current levels, we would expect the sector to be well supported. 

However, there are increasing risks emerging within the sector as well as associated pricing. As such, a more conservative approach to valuation pushing up capitalisation rates and not assigning aggressive multiples for other income streams, is warranted.

Given this late stage of the cycle, we prefer to have exposure to high-quality assets, AREITs with less cyclical factors and those trading at discounts that are out of favour. 

We have positioned our portfolios accordingly. The recent shift towards value with some reduction in risk behaviour has seen this approach start to outperform, while continuing to deliver good absolute returns.