A-REITs – Resilient growth supported by fundamentals

Australian REITs enjoyed strong returns in 2018 on the back of low interest rates, strong economic growth and strong investor flows.

The S&P/ASX 200 A-REIT index exhibited robust performance in 2018, gaining 14.7% versus 3.3% returned by the S&P/ASX 200 Index over the same period. The index has also had a great start in 2019 generating a return of 8.1% YTD

Source: CapitalIQ

Early in 2018, A-REITs’ pricing was negatively impacted by increasing bond yields and volatility in global share markets. Pricing recovered in the later quarters due to a decline in bond yields, stability and net incomes and strong revaluations growth in certain sectors.

Share prices rose to Net Tangible Asset (NTA) premiums in 2018 as market capitalisations and total returns rebounded, while further asset gains were a theme in the sector.

As at February 2019, the S&P/ASX 200 A-REIT index was trading at a 20.3% premium to net tangible assets.

Gearing ratios

Notes: Reflects median of sectors constituents and calculated as total debt divided by total assets
Source: CapitalIQ

Gearing ratios across all sectors of the A-REIT sector remained stable ranging between 25-40% and averaging 32%. In our opinion, this provides enough flexibility to take advantage of investment opportunities to create long-term value.

While debt was used to fund developments and acquisitions, this was offset by rising asset values on the back of continued compression in capitalisation rates.

With expectations of higher interest rates and a desire to undertake growth M&A at the right time in the cycle, boards and management remain focused on achieving balance between the risk of leverage and the lower cost of debt capital.

Earnings-based metrics (net debt/EBIT) is a key metric presented in this analysis in addition to the traditional gearing measure (debt/assets).

Source: CapitalIQ

Net debt to EBIT ranged between 3.5x and 6.2x, with a median of 5.5x. While Office REITs sat comfortably at the bottom end of that range, alternative REITs with low income yields and higher capital growth expectations were not unexpectedly near the top end of the range.

Retail REITs had the highest net debt to EBIT multiples, reflecting the structural challenges facing the sector and the high level of continuous investment required to attract and retain quality tenants.

Retail landlords are investing, seeking to build a competitive advantage, focusing on customer experience, and leveraging technology and data analytics to enhance the earning capacity of their assets. With further investment necessary in many assets, we believe capital raisings and/or transaction activity will accelerate in the near future for this sector.

Sector overview

Industrial property sector is in a strong growth phase, underpinned by exponential growth in ecommerce and infrastructure investment.

The Industrial property sector continues to deliver substantial growth, supported by population growth, infrastructure investment in Sydney and Melbourne, and the exponential growth of the online retail sector.

M&A and investment activity in the sector was strong with capital inflows from a number of offshore investors.

The expected continued growth of e-commerce, will result in higher asset valuations and yields for the industrial sector.

We also expect the Sydney market to continue to experience strong development-led growth supported by the second airport (which commenced construction in the second half of 2018) and the gradual move of a number of industrial and logistics hubs westward.

However, we expect a continued focus on scale and best of breed asset managers in this class –both from investors and tenants. We also expect consolidation in the sector as larger players with economies of scale, greater access to wholesale capital, and the ability to attract A-grade tenants, seek to grow their portfolios and footprint.

Retail property sector rebounds, in spite of online retail threatening the traditional sales industry

In 2017, the retail property sector faced a number of long-term headwinds. The impact of cautious consumer sentiment, sluggish sales growth and the rise of e-commerce placed pressure on re-leasing spreads.

However, in our opinion, investors had ignored important aspects of a number of the retail property trusts including that their ownership of “fortress malls” spanning large urban footprints, which have vacancy rates of less than 1% with low-income volatility due to their diversified tenant bases.

The sector rebounded in 2018 as investors recognised the strength of higher-grade retail assets.

Malls continue to adapt and evolve with increased focus on food, dining, entertainment and services amid the changing retail landscape, aiming to create social experience hubs.

Only time will tell what offerings will succeed and when the success will show. However, we expect that some of the global sentiment in the retail property sector is likely to play through in Australia in 2019 and is also likely to fuel consolidation activity.

Office property sector continues its stretch of going through a busy season

The Office property sector has displayed healthy returns, sourcing its growth from a strong rise in income, low vacancy rates, robust economic and population growth, along with weak asset supply.

Low vacancy rates are forecast to continue in larger markets with Sydney and Melbourne leading the way.

With strong organic growth, the completion of major infrastructure projects and continued large scale developments, we expect grade-A and more environmentally friendly office properties (which are replacing a number of older properties) to perform well.

Transaction activity

Outlined in the graphs below are the capital raising and M&A transaction activity in the listed A-REIT sector since the July 2017 quarter.

Consolidation activity continued in the A-REIT Sector

After a subdued start to 2018, there were substantial capital raisings by Centuria Metropolitan REIT ($276m), Cromwell Property Group ($228m) and Shopping Centres Australasia Property Group ($262m) in the last quarter. There was however only one IPO, Vitalharvest’s $185m IPO in June 2018. However, with some volatility in capital markets in the last quarter of 2018, a number of IPOs were put on hold or aborted.

The sector witnessed increasing investment in good quality office and industrial properties, which continue to attract a variety of domestic and offshore buyers. This played through in the listed markets with the takeover of Investa Office Fund and strong interest in Propertylink, which was subject to two takeover offers in late 2018. Offshore buyers also showed interest in sectors set to benefit from the continuing population growth and in particular the ageing population. This was illustrated by the takeover of Gateway in 2018 and continued interest from offshore in relation to Aveo, Stockland Retirement Living and Lendlease Retirement Living.

Challenges and outlook

As stated in the macro-economic outlook, the economic drivers of 2018, where residential property prices fell at the fastest rate since the Global Financial Crisis, exacerbated the difficulties faced by retailers where weak wages and the rise of online spending weighed on in-store sales. The industrial sector also had a mixed performance, with drought and rising energy prices challenging farming and manufacturing demand.

Looking forward possible fiscal policy changes on the back of state and federal elections could impede investment activity in the short to medium term.

Capital raisings will continue among existing players while we consider that continued global capital markets volatility could impede IPO activity. Notwithstanding, with the continued search of returns on the part of investors, we expect interest in alternative asset classes and specialist assets to increase.

This activity will seek to capitalise on bringing scale and the inability of market participants to access assets in the direct market, thereby encouraging the pursuit of capital partnerships.

We also expect to see continued interest (particularly from offshore), including from sovereign wealth funds, superannuation / pension funds and private equity.

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