What to expect from AREITs this reporting season

We expect a solid earnings season for the AREIT sector, driven by a strong recovery in retail which has been impacted by COVID; high earnings growth from the fund managers driven by strong AUM growth and performance fees; and record high settlements for residential developers benefiting from government stimulus such as the HomeBuilder grants. Combining these factors, we expect the REIT sector to generate average earnings growth of 12% for FY22.

Moving forward, with the rise in interest rates, the market will focus on:

1. cost of debt; 
2. asset value movements and 
3. development returns.

Since the RBA embarked on a tightening cycle in May 2022, cash rates have jumped from 0.10% at the start of the year to 1.35% at the end of July. This has meant that floating debt costs could be as high as 3.70% by 2023, which could have an impact on the earnings of REITs with higher gearing levels and low hedging profiles. As a whole, the sector’s capital position remains strong with an average gearing level of 27% (below the long-term average of 29% and well below the pre-GFC level of 45%). However, with the uncertainty of where interest rates will land over the next few years, we have adopted a level of conservatism and prefer REITs that have a strong balance sheet with low gearing levels and are well hedged over the medium term.

Where to from here for valuations? 

Based on the REITs that have reported on June 2022 property valuations, asset values have lifted on average by 3.5% whilst cap rates have remained flat. Looking forward, we expect the office sector to have the largest downside risk to valuation with cap rates expanding by 50 basis points. Cap rates in the retail sector can be expected to expand by 30 basis points whilst the industrial sector is likely to remain flat. The alternative sector and convenience shopping centres with their defensive cash flows will continue to benefit from cap rate compression.

In the past few years, REITs have significantly expanded their development pipelines to generate superior earnings growth. However, rising construction costs coupled with potentially expanding cap rates, are making project feasibilities more difficult. Our preference is for development projects in the industrial sector with favourable fundamentals in-tact (low vacancy rates of <1% for Sydney and high positive rental reversions of 10%-15%) or in the alternative sector such as childcare or healthcare where demand remains high. The significant increase in the cost of debt finance will also prohibit many players from commencing projects. This will favour groups with in-house development capability and strong access to third-party capital such as Charter Hall Group (CHC), Centuria Capital Group (CNI) and Goodman Group (GMG).

On a macro basis, we see the moderation of bond yields from the peak of 4.2% to 3.27% currently, as a positive for A-REIT sector performance, which has typically been negatively correlated to long-term bond yields. Market commentators are now expecting the RBA to cut rates as early as 2023, suggesting recessionary risks have now increased. We believe REITs with relatively stable earnings and attractive valuations represent a favourable addition to a portfolio and should lead to relatively strong performance.