With the clock ticking over to 2022, the world will have endured two years of COVID-19. Despite the well-documented challenges, 2021 has been a successful year for AREITs. The rebound, particularly following the success of the vaccine, demonstrates the unique nature of the pandemic for real estate and the resilience of the REIT sector. the Fund’s outperformance in 2021 was driven by the investment themes of funds management (CHC +43%, CNI +38%), logistics (GMG +42%, CIP +42%), and storage (NSR +45%), which is consistent with the prior year’s successful themes. Retail REITs (URW -6.5%, BWP -2%, VCX +9.8%) and diversified REITs (SGP +7.2%, CMW +7.9%) underperformed with structural shifts challenging these stocks, including online retailing and working from home.
Macroeconomic drivers remain strong for REITs with GDP growth of above 4% coupled with sound corporate balance sheets (average gearing for REITs at 27%) and household savings at an all-time high of 20%. However, three obstacles challenge the outlook over the near term, including ongoing high levels of COVID-19 infections, production and supply chain bottlenecks and an elevated inflation rate. The onset of the new Omicron variant will most likely place some caution on consumer sentiment and employees going back to the office. Whilst CPI remains high at 2.8%, driven by rising food and energy prices, sky-high shipping costs and persistent supply shortages will keep inflation around the top end of the RBA’s target band. The question is – will the RBA raise rates to curb inflation and, if so, how will REITs perform in this environment?
Firstly, we have adopted a conservatively high risk-free rate in our valuation of REITs providing us with a buffer in the event of further rate rises. Secondly, it has been shown that during periods of moderate inflation, REITs tend to outperform the broader market. This is because rents are not as sticky as other prices. Long-term leases typically have inflation protection built-in, and shorter-term leases are based on current price levels.
We are of the view that inflation is transitory and will subside as the pandemic is contained. With wage growth only approaching the 3% watermark, we don’t expect inflation to be at the high levels seen in the 1970s and early 1980s. To put things into perspective, interest rates are looking to rise but from a very low base. In this environment, we continue to see support for the REIT sector delivering a sustainable forecast income yield of 4%.
We continue to favour REITs with positive free cash flow and a strong balance sheet coupled with active managers who can add value through development and capital management. 2022 will be a year of continued structural shifts, favouring the growth of the alternative sectors and increased M&A activities as REITs look to grow and diversify earnings.
