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19-10-2014, 10:50 PM
Navigate a REIT selloff
Matthew Smith
1335 words
15 Oct 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Property Listed real estate trusts took a harsh turn last month but investors who understand an operator's business model may find value.
As a proxy for bonds, where regular income is the expectation, Australian real estate investment trusts have played their part to a tee during an long period of low interest rates. But for investors looking to stay with the segment, it's time to be selective.
It's likely that not all REITs will bounce back next time there is a selloff.
Following a sharp drop in the first half of September, the A-REIT index has held its value, whereas the broader S&P/ASX 200 index has kept falling.
Market watchers will say the aggregate selloff this time around represents the exit of foreign money; they will also caution investors there's another selloff likely around the corner when talk of an interest rate rise rears its head again. The next talk of a rate rise could lead to another 8 to 10 per cent drop in the value of the REIT index, says Morningstar senior research analyst Tony Sherlock.
However, the difference between the recent September selloff and the next selloff, Sherlock says, is that more REITs could be left behind when value returns.
Generally, talk of an interest rate rise and normalising of bond yields can be both good and bad news for A-REIT investors.
On the one hand, a rising interest rate is good because it means the monetary authority thinks the economy is improving, which in theory means vacancy rates should be dropping and revenues and earnings within the segment should improve.
On the other hand, it's bad because it means that demand for REITs will fall away, as investors who were pushed out along the risk curve in search of yield will find their way back into bonds as returns from fixed income becomes more attractive.
"Yes, it's true, bond proxies will generally sell off when interest rates go up, but you have to look through these short-term cyclical trends and an improving economy will benefit well-placed REITs over the longer term," says James Maydew, AMP Capital's deputy head of global listed real estate.
Maydew encourages investors to think about which REITs might be best placed to benefit from segments in the economy most likely to grow.
He points to storage and logistics REITs globally as likely to benefit from the increasing number of people buying and receiving delivery of products bought online.
In countries where there is an ageing population, Maydew says REITs exposed to the healthcare segment, including aged care and retirement facilities, will be well positioned.
"A lot of REIT investors will ultimately stop thinking about investing within the traditional retail, industrial and office categories and start thinking about REITs in terms of the segments of the economy they are exposed to," he says.
It's a fine idea, but the broadening of traditional REIT categories hasn't really happened yet in Australia to the extent it has overseas.
The industry-focused REITs on the ASX are generally small, including diversified property owner Folkestone, healthcare property owner Generation Healthcare and retirement communities owner and developer Ingenia. Recent entrants including age care provider Regis Healthcare and National Storage REIT have begun to take new REIT categorisations into the mainstream with some larger floats.
The best way to avoid finding yourself in a trust at risk of being left behind in the next selloff is to not be deluded by high yields, says Stuart Cartledge, the portfolio manager for the Cromwell Phoenix Property Securities Fund.
Investors should be critical of REITs – regardless of the type – with yields above 7 per cent, Cartledge says. He says he's seen plenty of REITs in the range with "manufactured" yields.
Cartledge says investors should be most wary of office REITs with high yields. "Retail REITs are getting a lot of negative headlines because of the disruption online [commerce] is causing in the segment, but office REITs have the potential for even more hidden traps," he says.
He points to the incentives landlords are increasingly paying tenants to stay on in office REITs as the factor most likely to make headline yields look more attractive than they actually are.
A Macquarie report released in September highlighted that office REITs haven't included incentives in their 2015 financial year guidance. "We include incentive amortisation in our earnings growth and hence our forecast growth is generally lower than that guided by office REITs," Macquarie researchers wrote.
Cartledge reckons accounting for incentives can knock as much as 20 per cent off the yield value of some office trusts. "Every office REIT I've seen is paying incentives. At some point these leases will expire, so not only will they have less income but they are also paying out incentives, so it's a double hit," he says.
Retail REITs are the other category singled out as potentially risky for investors, particularly in the event of another selloff; in particular those in which income is being eroded as tenants renegotiate cheaper rental agreements.
Because sales-per-square-metre has been dropping gradually as retailers deal with flat consumer activity, the landlords have been coming under increasing pressure to reduce rents at renewal time.
This phenomenon leads to negative re-leasing spreads and A-REITs with retail exposure have been among the hardest hit.
The Macquarie report singles out retail specialists CFS Retail Property Trust 1 and Scentre Group as having some of the biggest negative re-leasing spreads, in the range of 4.5 per cent to 5 per cent.
Across all categories, investors should be wary of REITs which pay out distributions that exceed their cash flows. In this category Macquarie highlights CFS Retail Property Trust 1, Cromwell Group, Federation Centres, Australian Leisure and Entertainment and Scentre Group.
But retail REITs also have their redeeming qualities, particularly the ones with larger well-placed centres. Cartledge believes retail REITs unnecessarily get a bad rap and points out the main retail REITs in the market are all mostly leased.
"While there is some negative re-leasing the main ones are all getting net income growth," he says.
"The thing is it's easy to build a new office tower; it's not as easy to build a new shopping centre," Cartledge says, describing the demand well-positioned centres are likely to continue to enjoy regardless of the future trends in retail. Sherlock points to the "kicker" the retail REITs based in prime locations are likely to enjoy if they are able to build residential developments onto their existing sites.
Without a doubt, prices of A-REITs across all segments are inflated, Sherlock says. He says it will be the most defensive REITs – those that have high yields and have been the outperformers in recent years – that will be hardest hit in the next selloff.
Macquarie describes the REITs at most risk as "the more vanilla rent-collecting REITs" that may have served a purpose as predictable generators of stable and defensive earnings and cash flows, but the bank says these vehicles will struggle to grow earnings in an environment where tenant demand remains subdued.
Demand for yield has kept these REITs, along with the rest of the segment, floating above their natural valuations.
According to investment firm JPMorgan, the A-REITs it researches ended September trading at a 20 per cent premium to their net tangible assets. Meanwhile, REIT capitalisation rates are below long-term averages and the spread to long-term real bond rates is also below average. Capitalisation rates for major Australian real estate sub-sectors have only been lower in the boom preceding the global financial crisis.
"These two reference points, combined with most A-REITs trading above asset backing, means prices are inflated," Sherlock says.
But rather than avoid the segment investors in REITs are being selective. It's always OK to be above average.
Fairfax Media Management Pty Limited
Document AFNR000020141014eaaf00033
Matthew Smith
1335 words
15 Oct 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Property Listed real estate trusts took a harsh turn last month but investors who understand an operator's business model may find value.
As a proxy for bonds, where regular income is the expectation, Australian real estate investment trusts have played their part to a tee during an long period of low interest rates. But for investors looking to stay with the segment, it's time to be selective.
It's likely that not all REITs will bounce back next time there is a selloff.
Following a sharp drop in the first half of September, the A-REIT index has held its value, whereas the broader S&P/ASX 200 index has kept falling.
Market watchers will say the aggregate selloff this time around represents the exit of foreign money; they will also caution investors there's another selloff likely around the corner when talk of an interest rate rise rears its head again. The next talk of a rate rise could lead to another 8 to 10 per cent drop in the value of the REIT index, says Morningstar senior research analyst Tony Sherlock.
However, the difference between the recent September selloff and the next selloff, Sherlock says, is that more REITs could be left behind when value returns.
Generally, talk of an interest rate rise and normalising of bond yields can be both good and bad news for A-REIT investors.
On the one hand, a rising interest rate is good because it means the monetary authority thinks the economy is improving, which in theory means vacancy rates should be dropping and revenues and earnings within the segment should improve.
On the other hand, it's bad because it means that demand for REITs will fall away, as investors who were pushed out along the risk curve in search of yield will find their way back into bonds as returns from fixed income becomes more attractive.
"Yes, it's true, bond proxies will generally sell off when interest rates go up, but you have to look through these short-term cyclical trends and an improving economy will benefit well-placed REITs over the longer term," says James Maydew, AMP Capital's deputy head of global listed real estate.
Maydew encourages investors to think about which REITs might be best placed to benefit from segments in the economy most likely to grow.
He points to storage and logistics REITs globally as likely to benefit from the increasing number of people buying and receiving delivery of products bought online.
In countries where there is an ageing population, Maydew says REITs exposed to the healthcare segment, including aged care and retirement facilities, will be well positioned.
"A lot of REIT investors will ultimately stop thinking about investing within the traditional retail, industrial and office categories and start thinking about REITs in terms of the segments of the economy they are exposed to," he says.
It's a fine idea, but the broadening of traditional REIT categories hasn't really happened yet in Australia to the extent it has overseas.
The industry-focused REITs on the ASX are generally small, including diversified property owner Folkestone, healthcare property owner Generation Healthcare and retirement communities owner and developer Ingenia. Recent entrants including age care provider Regis Healthcare and National Storage REIT have begun to take new REIT categorisations into the mainstream with some larger floats.
The best way to avoid finding yourself in a trust at risk of being left behind in the next selloff is to not be deluded by high yields, says Stuart Cartledge, the portfolio manager for the Cromwell Phoenix Property Securities Fund.
Investors should be critical of REITs – regardless of the type – with yields above 7 per cent, Cartledge says. He says he's seen plenty of REITs in the range with "manufactured" yields.
Cartledge says investors should be most wary of office REITs with high yields. "Retail REITs are getting a lot of negative headlines because of the disruption online [commerce] is causing in the segment, but office REITs have the potential for even more hidden traps," he says.
He points to the incentives landlords are increasingly paying tenants to stay on in office REITs as the factor most likely to make headline yields look more attractive than they actually are.
A Macquarie report released in September highlighted that office REITs haven't included incentives in their 2015 financial year guidance. "We include incentive amortisation in our earnings growth and hence our forecast growth is generally lower than that guided by office REITs," Macquarie researchers wrote.
Cartledge reckons accounting for incentives can knock as much as 20 per cent off the yield value of some office trusts. "Every office REIT I've seen is paying incentives. At some point these leases will expire, so not only will they have less income but they are also paying out incentives, so it's a double hit," he says.
Retail REITs are the other category singled out as potentially risky for investors, particularly in the event of another selloff; in particular those in which income is being eroded as tenants renegotiate cheaper rental agreements.
Because sales-per-square-metre has been dropping gradually as retailers deal with flat consumer activity, the landlords have been coming under increasing pressure to reduce rents at renewal time.
This phenomenon leads to negative re-leasing spreads and A-REITs with retail exposure have been among the hardest hit.
The Macquarie report singles out retail specialists CFS Retail Property Trust 1 and Scentre Group as having some of the biggest negative re-leasing spreads, in the range of 4.5 per cent to 5 per cent.
Across all categories, investors should be wary of REITs which pay out distributions that exceed their cash flows. In this category Macquarie highlights CFS Retail Property Trust 1, Cromwell Group, Federation Centres, Australian Leisure and Entertainment and Scentre Group.
But retail REITs also have their redeeming qualities, particularly the ones with larger well-placed centres. Cartledge believes retail REITs unnecessarily get a bad rap and points out the main retail REITs in the market are all mostly leased.
"While there is some negative re-leasing the main ones are all getting net income growth," he says.
"The thing is it's easy to build a new office tower; it's not as easy to build a new shopping centre," Cartledge says, describing the demand well-positioned centres are likely to continue to enjoy regardless of the future trends in retail. Sherlock points to the "kicker" the retail REITs based in prime locations are likely to enjoy if they are able to build residential developments onto their existing sites.
Without a doubt, prices of A-REITs across all segments are inflated, Sherlock says. He says it will be the most defensive REITs – those that have high yields and have been the outperformers in recent years – that will be hardest hit in the next selloff.
Macquarie describes the REITs at most risk as "the more vanilla rent-collecting REITs" that may have served a purpose as predictable generators of stable and defensive earnings and cash flows, but the bank says these vehicles will struggle to grow earnings in an environment where tenant demand remains subdued.
Demand for yield has kept these REITs, along with the rest of the segment, floating above their natural valuations.
According to investment firm JPMorgan, the A-REITs it researches ended September trading at a 20 per cent premium to their net tangible assets. Meanwhile, REIT capitalisation rates are below long-term averages and the spread to long-term real bond rates is also below average. Capitalisation rates for major Australian real estate sub-sectors have only been lower in the boom preceding the global financial crisis.
"These two reference points, combined with most A-REITs trading above asset backing, means prices are inflated," Sherlock says.
But rather than avoid the segment investors in REITs are being selective. It's always OK to be above average.
Fairfax Media Management Pty Limited
Document AFNR000020141014eaaf00033