Why REITs, why now?

The last financial year was all about the rising cost of capital in response to stubbornly high inflation rates. This led to three themes that dominated the market:

1. Balance sheets are under scrutiny as the cost of refinancing rises
2. A wide gap in valuation between direct property and listed markets
3. Effects of the pandemic still linger in places such as the office market with the WFH thematic, and developers are still grappling with labour shortages and high construction costs due to inflation.

Looking ahead, inflation seemed to have peaked but it remains significantly higher than the RBA’s target range (2-3%). In this environment of high inflation, high interest rates, and low growth, here are the key questions that we want to address:

1. Can the AREIT sector grow earnings into FY24 given the impact of higher rates?

The inflation hedge characteristics of REITs with rental growth often linked to CPI have generated an estimate of 5% in headline earnings growth. However, with the significant rise in the cost of debt (from 2.5% to now ~6%) earnings growth at the FFO line has halved. The ability to deploy capital effectively is key to achieving earnings growth.

Our approach

We look for resilience in earnings. This can be achieved by having a strong balance sheet with debt that is well hedged so that there’s certainty in cash flow. The Fund will only invest in REITs with an ICR of >3 times. Another way is to have resilience in income by investing in sub-sectors that have strong operational matrices such as logistics over office, and alternative sectors such as childcare, healthcare, data centres, and retirement living. As some of these alternative assets are deemed necessities, they are less cyclical than traditional real estate sectors such as office, retail, and industrials. Our Fund currently has more than 25% exposure to these resilient assets and 30% exposure to the logistics real estate sector.

2. Where will valuations end up and can the gap be closed?

Whilst cap rates and asset values are finally starting to move, reflecting the higher cost of capital and emerging transactional evidence, we believe REIT valuations are generally still too high, providing ongoing risk to NTA, balance sheet gearing, and investor sentiment. Based on the companies that have reported revaluations so far, the average shift in cap rates is 25bps since Dec-22 and 33bps since Jun-22. Given the ~250-300bps increase in 10Y bond yields and 300-350bps increase in the marginal cost of debt, we are surprised that cap rates have moved up only this far.

The greater expected cap rate movements are arguably already reflected in share prices, with a majority of REITs trading at a 20%-30% discount to their book value. The key to closing the gap is either bond yields moving down and/or REITs achieving earnings growth to offset the rise in the cost of capital and cap rate expansions.

Our approach

We take a forward view of cap rates when calculating our NAVs. Our financial models incorporate expansion in cap rates (+30bps for retail, +50bps for industrial, and +70bps for office). We expect high-quality portfolios with strong rental growth to offset cap rate expansions and thereby maintain valuation such as the logistics sector (which is under-rented and experiencing double-digit rental growth), whereas the office sector (with leasing challenges) has got more downside risk.