How this AREIT investor is approaching reporting season

2023 brings new optimism into the REIT sector with a slowing of cash rate hikes as inflation moderates, along with potentially the start of a cash rate easing cycle later in the year. As a result, REITs bounced strongly in January up +8.1%, outperforming the broader market by 2% and reversing some of the underperformance from 2022.

As we head into the reporting season, key areas of focus for our team are:

1. Capital management – With the rising cost of debt, we remain focused on how companies manage their balance sheets and hedging profiles. Well capitalised companies should be able to take advantage of the expected decline in asset values through acquisitions, be less impacted by rising interest expenses and continue to grow their development pipeline. As a result, we favour Real Estate Fund Managers with lower cost of capital and REITs that can recycle capital through selling non-core assets to strengthen their balance sheet or re-deploy into their development pipelines.
2. Asset valuations – We expect asset values to correct in the order of 13% from their peaks, as investors’ required returns have risen from around 6.50% at the start of 2022 to 7.25% today due to the rising cost of debt. The sub-sector with the highest downside risk in our view is office. The growth outlook for the sector remains weak with the challenges of the WFH (work from home) thematic still playing out, combined with high vacancies and incentive levels holding back net property income.
3. Sustainable earnings – We expect most REITs to reaffirm their FY23 earnings guidance. With the macro concerns now well understood, we expect medium-term outperformance to be driven by sustainable growth strategies. This means that management will have to demonstrate that they are best of breed in their selected asset classes and position the portfolio to benefit when the interest rate cycle turns.
4. Residential sector – The sector has been faced with a challenging year of i) rising cash rates that are still to affect a large portion of borrowers on fixed-rate mortgages; ii) declining affordability; and iii) construction cost inflation. We believe that a portion of the residential downturn has been played out through the second half of 2022. Looking ahead, a number of factors bode well for a recovery of residential REITs including 1) introduction of First Home Buyers Choice to make home ownership more affordable; 2) return of immigration to pre-COVID levels; 3) low vacancy rates; and 4) the RBA potentially cutting rates in late 2023.

Combining the above factors enables us to focus on defensive exposures in the current environment, together with select positions in REITs that provide growth upside. We favour REITs with exposure to convenience retailers and the Alternative sectors, such as retirement living, childcare, healthcare and data centres, for sustainable earnings. Our exposure to logistics, Real Estate Fund Managers and residential REITs provide upside in terms of valuation and earnings growth.

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