Where to from Here for AREITs?

Fifty years ago, General Property Trust (GPT) listed on the ASX. In so doing, it changed the lives of income investors for good.

Since then, Australia has become a global leader in listed commercial property. Local and offshore investors have been attracted to the relatively high income of AREITs and their competitive, risk-adjusted returns.

Then came Covid and an altogether different environment tailormade to tarnish the sector.

The mighty Westfield had put Australia on the map as a global retail real estate leader but also gave us one of the highest exposures to retail real estate in the world. Within a few days of lockdown, shopping centres were empty with the enforced switch to online seeing several years of growth compressed into a few weeks.

In offices across the country a similar shift was taking place. Having prevaricated for years over the pros and cons of working-from-home, managers and their staff were surprised at how smoothly and quickly the transition occurred.

These factors were the writing on the wall for the AREIT sector. Having reached a high over 64,000 in late February 2020, the ASX300 AREIT accumulation (total return) index fell 37% in March as investors tried to comprehend the implications of the unknown. Shopping centre stocks were amongst the hardest hit, notably the large mall landlords Scentre (down 55%) and Vicinity (down 52%) as investors panicked around whether their shopping centres would ever re-open.

ASX300 (Equities) vs AREIT300 Accumulation Index

Source: APN Property Group, S&P

The forlorn outlook many experts predicted back then hasn’t eventuated, with Australia’s largely successful control of the pandemic getting much of the credit. Those offshore investors that ran for the hills last March have since turned tail, realising Australia was a better place to invest in a pandemic.

AREITs have since recovered significant ground with the vaccine announcement delivering a further boost. Still, the sector continues to trail the broader Australian equity market recovery (refer above chart) which is an opportunity for investors focusing on the long term.

The structural concerns that first surfaced as the pandemic took hold, along with the absence of international tourists and immigration, explain much of the gap. The Government-mandated Leasing Code of Conduct was also a significant burden (not placed on most businesses) for landlords.

The code removed a tenant’s obligation to meet contracted rental payments under the lease contract, meaning landlords were having to support their business partner (tenants) which created great uncertainty for investors. As some support is still being provided, this continues to weigh on the sector’s recovery.

Thus far, AREIT landlords have provided more than $1b in support under the Code, with almost all of it ( more than 90%) delivered by owners of retail properties (notably large malls).

The unintended consequence is that those businesses most impacted by the pandemic – namely large mall landlords, Scentre and Vicinity – have provided the highest levels of tenant support. The impact on their bottom lines has been pronounced and prolonged.

Where are the opportunities?

While all AREITs have recovered significantly from their March 2020 lows it is in the dispersion of that performance where opportunities lie. Those AREITs currently trading well below their pre-pandemic 2020 highs include Vicinity (down 40%), Scentre Group (down 34%) and GPT (down 27%) all of whom were burdened with additional Covid impacts (Lockdowns and the leasing Code).  These names will recover, providing solid returns to investors focused on the long term.

However, as always, there’s a caveat. AREIT performance is inextricably linked to the Australian economy. On that score, the ongoing recovery will be boosted by six factors:

1. a return to the office will assist struggling CBD retail as foot traffic rises;
2. price growth in residential property and ongoing construction will boost retail, especially DIY and homeware categories and improving consumer confidence. Consumers’ willingness to spend, a key plank in the path for a return to pre-Covid life, should gather pace;
3. the vaccine roll-out will further lift business and consumer confidence;
4. the return of international tourism, potentially exceeding prior levels (revenge travel as consumers look to catch-up), should have a similar impact;
5. as will the return of international students, with residential and retail property clearly benefiting. Overseas students can also help us address current labour shortages; and
6. the return of immigration will be a major economic driver and, as with foreign students, residential real estate will be a major beneficiary, with flow on benefits for office/retail and other real estate sectors.

These factors point to AREITs performing well over coming years. Between 2010 and 2019 AREITs returned 11.6% p.a. (mainly from income). According to UBS data, over the past 20 years AREITs have delivered an average return of 9.6% a year, including an average distribution yield of 6.9% p.a. The income investors received is almost 50% higher than equities over this period.

This is a key takeaway for income investors – it is the income component of AREIT returns that is the most predictable. With the recovery underway, investors can again expect to rely on it.

The risks

The major risks to the AREIT sector concern all those factors that may apprehend the economic recovery. Inflationary pressures that may result in higher interest rates, damaging the wealth effect, the continued slow pace of vaccine rollout and more damaging mutations should all be considered. While inflation has become a growing concern across financial markets, it could see more investors turn to commercial real estate which has leases that have inflation linked or fixed rental escalations providing a level of protection that other asset classes cannot provide.

And there remain unknowns in the office and retail sectors, although in our view these are diminishing each day. In sticking to high quality, well-located properties with premium tenants, as APN Property Group likes to do, these risks can generally be offset.

Three major trends

1.  The benefits of funds management earnings to AREIT growth

In recent years, Charter Hall and Goodman Group have grown their funds management operations. Their moves proved prescient. Covid highlighted the reliability of their earnings under significant market stress. As recognised leaders in real estate asset management, the growth in funds management earnings by AREITs is set to continue.

2.  Not all retail is created equal

Large malls with heavy exposure to discretionary retail suffered from lockdowns and reduced foot traffic while non-discretionary convenience centres underpinned by supermarkets thrived. Large format retail (LFR) centres, meanwhile, fed our demand for homewares, electrical, furniture and everyday needs. A recent LFR transaction occurred at a 50% premium to the December 2020 valuation. Post-Covid, most assets will continue to deliver healthy income but investors should remember not all retail is created equal.

3.  Say hello to new commercial property asset classes

Already, there are two listed Childcare (or social infrastructure) REITs with more to come. Hotels (pubs) and primary produce is another sector getting attention from commercial property investors with FY21 seeing a record year of transactions. Service stations assets also deliver bond-like returns but with growing income, underpinned by high quality tenant covenants and strong investor demand (2020 saw a record level of transactions) with the added benefit of alternative use potential (when electric vehicles dominate our roads). The future AREIT index may look more like its US counterpart, where commercial property investors can add healthcare properties, life science and government buildings and even mobile phone towers to their portfolios.