2022 was characterized by sharp movements in bond yields and cash rates rising steeply in response to higher inflation. The impact on A-REITs was felt primarily through higher debt costs, impacting on cost of capital and required returns on investments. A-REITs caught out by higher floating rate debt costs were punished by investors over 2022 and those with sound hedging levels and balance sheet positions were rewarded.
Looking at each of the sub-sectors, retail REITs were the best performer as foot traffic returned to malls after a COVID-impacted 2021. Surprisingly throughout the year, consumers proved remarkably resilient in the face of higher inflation and rising interest rates. We attribute this to a lagging effect between changes in the cash rates and adjustments to mortgage payments, as around 35% of households have fixed-rate mortgages and around 60% of those will expire by the end of next year. As a result, we anticipate retail sales, particularly discretionary retail, will become weaker at a time when real disposable incomes are falling, and the savings rates are nearly back at pre-pandemic levels.
The office market is still challenged despite the re-opening post COVID lockdowns. Physical office occupancy is still low at 58% as the work-from-home (WFH) trend is becoming entrenched. More people are choosing at-home or hybrid working arrangements, reducing their commute to work in the office from 4.2 days to 3.6 days. The estimated impact will be a reduction in demand for space with mitigating factors including a flight to quality. When we combine the structural shift of WFH with the increase in supply over the next 2 years for the major capital cities, the outlook for office is a sustained weak operating environment with expected high vacancies of 12%-15% and high incentive levels of 30%-40%. While this is largely reflected in implied cap rates, it is not yet captured in book values (e.g. Dexus Group (DXS) was trading on an implied cap rate of 6.3% as of 31 December 2022 compared to its book cap rate as of 1H23 of 4.9%).
Industrial assets, particularly infill logistics, continue to benefit from strong rent growth as vacancy rates are at record lows, particularly for South Sydney at 1.5%. CBRE indicated rental growth for prime assets for the year was at 25%. Early evidence from 1H23 valuation updates highlighted that strong rent growth had largely offset the impact of cap rate expansions.
Fund Managers underperformed in CY22 as interest rates lifted sharply. The rise in rates affects the Fund Managers in two folds:
- It impacts the valuation of their existing assets, putting pressure on FUM; and
- It increases the cost of capital, making acquisitions and developments less attractive, thereby impacting on future growth.
We believe Fund Managers have been oversold and are trading at attractive valuations.
As we head into 2023, the crucial question is “are we moving into a regime of structurally higher rates, or will rates come back down?” We are firmly of the latter view, which is supportive of the listed real estate market. On some metrics, the A-REIT sector has rarely looked this cheap. As of 31 December 2022, the sector was trading at an 18% discount to NAV, a 20% discount to NTA (excluding CHC and GMG), and an average PE ratio of 14x. We believe stabalising interest rates will support the sub-sectors that have been oversold, including Fund Managers such as Charter Hall Group (CHC), Centuria Group (CNI), and HMC Capital (HMC).
The Fund continues to focus on free cashflow, sustainable earnings, and a strong balance sheet. We favour the logistics sector and Fund Managers based on quality and growth, and the alternative sub-sectors for their defensive earnings.
