Investors in Australian property have long been enamoured with the residential market, but away from the fanfare and the media focus, Australian Real Estate Investment Trusts (AREITs) offer many of the same attractions, but with broader sub-sector opportunities and much deeper liquidity.
The AREITs universe provides investors with exposure to a diverse range of listed real estate securities within several sub-sectors, including retail, office and industrial. And while there are a number of common factors across these sectors, given the long duration nature of the asset class, a variety of income streams and strategies exist at both the sector and stock level that produces a significant dispersion of returns that an experienced active investor can take advantage of.
Just like with the residential sector, investors have been rewarded with strong performance from the AREITs asset class in recent times, with the S&P/ASX 300 AREIT Accumulation Index returning 16.2 per cent per annum over the five years to the end of April 2017.
Given this strong performance, investors are right to ask what the long-term opportunity is and what the prospects are at the sub-sector level.
Is now the time to enter?
Steady and reliable distributions have been a welcome attraction for investors in the AREITs asset class, particularly in an environment where the yields on traditional income generators have been compressed.
For instance, the yield on the Australian 10-year government bond has declined from over 5.5 per cent in mid-2011, to approximately 2.6 per cent today1. The distribution yield on AREITs at 4.8 per cent1 is relatively attractive compared to traditional providers of income, though this too has come down.
Indeed, while this distribution has been important in the index’s total return, a more significant portion has come from growth in capital. And this is a relevant consideration for those who may be underweight the asset class, or looking to increase their allocation and who may be wondering whether now is a good point to enter.
In fact, Net Asset Values (NAVs), or the current value of a trust’s assets minus its liabilities, have gone up a lot in recent years, with the physical market becoming quite ‘toppy’. One way to measure this for an individual asset is by considering the ‘cap rate’, or the asset’s Net Operating Income compared to its market value. Current ‘cap rates’ are relatively low. While we have seen a steady improvement in income, today’s low ‘cap rate’ is more a function of the expansion in market values.
Going forward, further improvement in NAVs is expected to be more driven by growth in Net Operating Incomes.
The other factor to consider here is that the discount to NAV is currently fairly modest at only 3 per cent1, which, while fair, cannot be considered that compelling given the move in NAVs noted earlier. This assessment is also supported by a comparison of the Price-to-Earnings ratio of the AREITs index to the broader equity market. Currently, AREITs are trading at a similar valuation to general equities against a long-term average of being moderately cheaper.
So, while the distribution yield for the sector (at close to 5 per cent) continues to be relatively attractive, particularly when compared to what is available from the bond market, the current physical valuation might perhaps prompt some short-term caution regarding a fresh allocation to the asset class.
Is there value in retail real estate?
At the sub-sector level, retail accounts for approximately half of the index, though the underlying exposures are varied across quality of assets (think of the premium locations of Westfield against some of the regional malls), as well as by location (for instance, key index stock Westfield Corp primarily has exposure to the US and the UK).
Currently, underlying retail sales are soft and conditions are made tougher for local players as foreign entrants eye the Australian market. The threat of online has also been elevated by confirmation that Amazon will be launching Amazon Marketplace in late 2018.
While this has weighed on the trusts that are exposed to the retail sub-sector, this can be expressed by an underweight exposure by an active manager. It’s also important to recognise that at some point, this threat will be ‘priced in’ to the underlying trusts and may even present an opportunity to those investors with a long-term view. The retail experience may be changing, but AREITs still provide equity ownership to some of the highest quality real estate in Australia.
Cranes and opportunities in office
While cranes on the skyline are the traditional barometer of economic activity, the lack of them (in Sydney anyway) has proved to be more telling. While all metro markets have their own specific drivers, the outlook for the Sydney office market is positive.
Historically, low supply in the Sydney CBD is expected to drive the vacancy rate below 5 per cent, which supports the prospect for strong effective rental growth over the next few years. Sydney is important in the context of AREIT office exposure, as it accounts for over half of the sub-sector.
Melbourne is also expected to deliver steady improvement in rental growth, though the prospects for Perth and Adelaide are less compelling as vacancy rates are high.
What about residential?
Residential always sparks interest, despite the low exposure (under 5 per cent) that the AREITs index has to the residential property market. Despite the concerns discussed in the press, the current environment has remained strong, with the two key listed trusts, Mirvac and Stockland, reporting record levels of pre-sales and have even guided to increased margins, as prices have risen further in Sydney and Melbourne.
However, this is moderated by a somewhat gloomier medium-term outlook, particularly for those trusts that are more exposed to the huge increase in apartment supply that has been seen in Melbourne and Brisbane. The longer term outlook is also clouded by the overall level of affordability that is back to historic lows (even with historic low interest rates).
Where do trains fit in?
On a longer term outlook, the Government’s infrastructure initiatives are worth keeping in mind. While the Melbourne to Brisbane Inland Rail project is still at a very early stage, there will be important implications, and opportunities, for property, as these transport and logistics plans are progressed.
What about small cap REITs?
While there is a tendency to focus on the larger cap stocks within the index, there is a ‘long tail’ of smaller trusts across a diverse range of sub-sectors, including hotels, pubs and lifestyle communities. Some of these even sit outside the index and can be under-researched and under- owned, offering an attractive opportunity for an active manager with the right investment approach that can take advantage of these inefficiencies.
Active management to capitalise on mispricings
Given the diversity of prospects at both the sub-sector and stock level, finding an experienced active manager can greatly assist in navigating a market where the overall return outlook for the broader index is relatively muted and largely relates to the distribution yield opportunity, at least in the short-term. The case (for active) is well supported by the dispersion of returns amongst the individual trusts, with different strategies and income streams creating different risk and return characteristics.
Mispricing opportunities can also be created by the composition of the buy-side, with various types of investors applying differing valuation criteria. An experienced investment team that conducts in- depth fundamental research to drive conviction can position an AREIT fund to exploit these opportunities.
Charles Stodart is an Investment Specialist at Zurich Investments