A-REITs - Safe as houses
In this paper our Multi Asset and Credit team revisit the yield play and how this impacts our thinking around A-Reits
“Real estate is always good as far as I’m concerned.” – Donald Trump
We last documented our views on the AREITs in November 2014 and our conclusion was not greatly different to our current view; that AREITs are much overvalued in a world distorted by a reach for yield. Yet, AREITs have continued their outperformance of Australian equities (by 18% in annual total returns since Dec-14) and it has become clear that the cluster of increasingly expensive fixed income proxies in the equity market of which AREITs are the most obvious (Exhibit 1), are unlikely to show their true capital risk until investors stop treating anything with income as a guaranteed return vehicle.
AREIT equity has continued to climb reflecting the commitment and pervasiveness of Central Bank policy depressing long term bond yields and supporting yield based assets more broadly. However, we still maintain that the biggest risk to the sector is an increase in interest rates or a loss of confidence in Central Banks, which will have a significant impact on the AREITs, particularly given the sheer volume of capital which has flooded the sector over the past few years. This is evidenced by the 2013 ‘Taper Tantrum’ where, on an annualised total return basis, the AREITs underperformed Australian corporates by 13%. The other risk is an Australian recession.
Exhibit 1: Correlation between AREIT equity and long run bond yields.
The fundamental picture is not supportive of current valuations and has been consistent with our longer term assumptions of subdued effective rental growth, anaemic demand and high incentives which continue to be offered by asset owners. As a consequence, our investment conclusions remain unchanged. AREIT equity offers little incentive for investors relative to broader equities given the overdone valuations and cyclical vulnerability however pockets of value remain within the AREIT corporate debt sector, where we maintain exposure in the credit components of our portfolio.
Looking at fundamentals the picture is one of low income growth and stable occupancy in the stronger markets of Sydney and Melbourne, but Perth continues to decline and is likely to remain in this state for some time to come.
Whilst there is no doubt that demand is more subdued, the substantial over-supply that was forecast to result from Lend Lease’s Barangaroo development in Sydney has not materialised. Ongoing restructuring of tier-1 legal firms and investment banks saw the market brace for higher vacancy and resulting weaker fundamentals, but conversely leasing activity actually held up, supported by building withdrawals and new leasing demand from technology firms such as Google, Amazon and most recently Alibaba, as well as other non-traditional occupiers of CBD space. This may support some Sydney rental growth over the next 1-2 years.
The supply pipeline for office markets across the country, tapers considerably post 2016 (source: JLL), which is good news for net absorption, but whilst connected, vacancy does not tell the whole story. Incentives and net effective rents provide a more complete picture of market health and as of the first quarter 2016 Sydney was the only market to report a decline in incentives, and that was only at the margin.
CBD prime office incentives average circa 30% today (source: Colliers), a level only previously experienced in 1992 when vacancy was considerably higher. So whilst occupancy is holding up, reported prime CBD net effective rental growth is very close to zero if not negative (Exhibit 2 and 3), which reinforces our low nominal growth assumption.
Exhibit 2 and 3: Prime CBD office and industrial net effective rental growth
Source: Credit Suisse and JLL
Whilst Sydney and Melbourne net absorption has surprised on the up-side, Perth is testament to why caution is advisable. The decline in mining investment in Western Australia has materially impacted the real estate market. Net effective rents for prime office space have fallen as much as 21% year on year (source: JLL Mar-16 compared to Mar-15). In February this year the Property Council of Australia announced that vacancy for Perth CBD had reached a 21-year high at 19.2%, which demonstrates how quickly the cycle can revert.
Industrial real estate net effective rents have also been in decline reflecting increasing supply in 2014 and 2015 supported by low development barriers. Incentives range anywhere between 10 – 25% depending on location, largely as a factor of supply, given demand for space across the major industrial markets (Sydney, Melbourne and Brisbane) has been supported by the growth of distribution and warehousing. The supply pipeline is forecast to decline towards the end of the decade which should support a stabilisation of rents.
Retail property (shopping centres) had another record year with capital values continuing to increase across prime and secondary assets. Retail generally benefits from a more stable rental growth profile than its office and industrial counterparts. Re-leasing spreads have been improving with lower interest rates and a weaker Australian dollar being supportive of sector performance. Incentives however are still being offered on new leases, which is an indication that fundamentally the sector is not as healthy as it was prior to the GFC. The growth of online retail continues to be a threat but is largely being managed through Centre re-mixing towards entertainment and lifestyle. Planning and development regulations in Australia limit supply of retail property, which continues to be a significant benefit to the sector.
Overall our view of the fundamentals has not changed and we do not expect a significant shift in this outlook so long as domestic participants remain relatively rational about future supply. Property fundamentals continue to be largely driven by macroeconomic factors including unemployment and interest rates. Challenges do exist within each market but they should not be material enough to have a significant impact on gross operating performance.
As major beneficiaries of the low interest rate environment and the ongoing flow of capital into Australian real estate it is to be expected that the AREITs would have used the opportunity to re-gear to some degree. This has proven to be the case. In August 2012 gearing for the listed AREITs fell to a low of 29% (total debt to total assets) compared with today where gearing averages 32% and compared to August 2008 where gearing hit a high of 39%. Although on an asset basis it may appear that leverage is now more conservative, this is largely due to the lower cap rates applied to underlying cash flows and when leverage is assessed based upon income (Total Debt to EBITDA) the current ratio at 9x is not materially different to the position many AREITs found themselves in 2008. See Exhibit 4.
Exhibit 4: Financial leverage
The Valuation Picture
Amidst fears of deflation the continued outperformance of long duration bonds has resulted in low and in some cases negative forecast returns from these assets. However, investors are using the AREITs as a proxy for fixed income assets which has resulted in the REITs trading at even poorer levels of valuation in reflection of the same fear. Our return forecasts suggest a high risk of negative returns from bonds and bond proxies (like AREITs) over the medium term, as can be seen in Exhibit 5, which charts our prospective 3 year return for the major asset classes against the risk of losing money in any 12 month period over the next 3 years.
Exhibit 5: 3 year expected returns vs probability of loss
Source: Schroders as at 31-May 2016
Our long-held view that the position in the capital structure, perpetual duration and observed volatility makes AREIT stocks far more equity-like than debt-like however we concede this is not a broadly-held market view. The assumptions and resulting expected returns for Australian equities and AREITs are summarised in the waterfall charts, Exhibits 6 and 7. They highlight why our return forecasts are significantly different for Australian equities and AREITs.
Exhibit 6 and 7: Expected returns for Australian equites and AREITs
None of our primary assumptions from 18 months ago have changed. Australian equities offer higher yields plus the benefit of franking, Australian equities offer higher longer term growth prospects due to structural constraints of AREITs. Most importantly we believe that Australian equities after five years of going sideways through a decline in the profits cycle are now at or slightly below fair value whilst AREITs having been anchored to the bond cycle are very over-valued. This relationship is highlighted in Exhibit 8, which shows the relationship between AREIT yields and the long term bond yield adjusted for an investment grade credit premium.
Exhibit 8: Carry Trade Model – AREIT yields vs total cost of corporate debt
Source: Schroders, Bloomberg, Credit Suisse, JLL
The danger of using the AREITs as fixed income proxies and ignoring the equity risk premium is the potential for significant capital destruction when the equity risk is eventually re-priced (from Jan-02 to May-16 the volatility of returns on the ASX 200 AREIT Index was 16% compared to 13% on the ASX 200 and just 2% on the Australian corporate bond index). However, in an environment of falling bond yields and tightening credit spreads, the reach-for-yield has caused many investors to somewhat disregard this notion, and as yet, we have not seen a re-pricing of risk. Nonetheless the picture today even using the ‘carry-trade’ view has changed, with Australian 10-year government bonds hovering around 2-2.5% and a widening in credit spreads shows AREIT yields are now tighter than such a model suggests is warranted.
We see better value on the debt side of the balance sheet
Whilst investors are not being paid the equity risk premium for their investment in the AREIT equity, we propose that the corporate debt looks attractive on a valuation basis. We maintain an overweight position in AREIT corporate debt which benefits from a higher position in the capital structure, lower volatility and not being exposed to perpetuity risk. This can be seen in our return forecasts for Australian investment grade corporate debt (Aus IG Credit) in Exhibit 5.
It is not just the listed market that has become carried away with extremes of valuation as the underlying assets themselves have also reflected the same investor behaviours in the unlisted market.
The flow of capital from sovereign wealth and global pension funds combined with an in increase in direct domestic and offshore investment into Australian real estate assets has been very supportive of the aforementioned carry-trade. Valuations of individual assets have been steadily rising, evidenced by significant capitalisation rate compression post the GFC. This phenomenon is present Australia-wide, even in the relatively weaker markets of Perth and Brisbane and despite a subdued outlook for income growth and lacklustre fundamentals within the sector.
The disconnect between face rents upon which valuations are based and effective rents received after incentives (rent-free months and free fit-outs/refurbishments) which actually support current cash flows is one of the enduring property valuation puzzles. Exhibit 9 illustrates implied cap rates of Sydney Office, Melbourne Industrial and Super Regional Malls based upon effective rather than face rents and supports our view that valuations are stretched.
Exhibit 9: Capitalisation rates for various property assets
Conclusion and implications
Since the GFC the Australian property sector has benefited from a two-fold windfall being the ‘lower for longer’ interest rate environment driving down the cost of debt and the significant growth in foreign capital investment driven by investors’ insatiable desire for yield. Cap rate compression combined with falling debt costs has done much to improve AREIT balance sheets; however we are concerned that lacklustre operating fundamentals are unsupportive of physical valuations on the underlying assets.
As a consequence we continue to avoid AREIT equity reflecting our view that valuations are not commensurate with the risk to which investors are exposed. We are concerned that as risk is re-priced there is a high probability that bond-proxies like the AREITs will suffer negative returns. AREIT corporate debt on the other hand still offers reasonable value in a broader portfolio context.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.