Five key takeaways from AREIT reporting season HY24
Article10 mins18 March 2024
They say that it is darkest before dawn. If that is true, then the results from the latest half-year reporting period might be a sign of the sun about to rise. Here are our five key takeaways.
1. Expectations changing, AREIT share prices rising
During the first six months of calendar year 2023, Australian REIT investors had to battle with four more interest rate hikes. Facing a fifth last November, sentiment towards the property sector was subdued. When the S&P ASX AREIT 300 index hit rock bottom in October 2023, year-to-date returns were -8.2%, 4.3% behind the broader S&P ASX 300 Index.
In the last two months of the 2023 calendar year, attitudes began to change. This was reflected in the overall total returns for the period, with the AREIT index producing a total return of 13.0% through the final six months of the calendar year, or the first half of financial year 2024, outperforming equities by 6.5%.
A change in expectations explained the difference. As inflationary forces eased, central banks paused and commentary on interest rates turned from wondering whether there would be an easing cycle to asking when it would start. This attitudinal change that drove the sector’s returns through HY24, particularly towards the end of it.
This period may be remembered as the inflection point for sector returns as the effects of the interest rate tightening cycle abated. This was identified in our wrap of the FY23 reporting season, where we highlighted research from Citi showing AREITs outperformed in two of the past three RBA interest rate cutting cycles. That outperformance began at the plateau before interest rate started to fall. If history repeats, this is the time of opportunity.
2. Beware the gorilla in the index
Whilst index figures have their uses, in the case of the ASX AREIT 300 index one must acknowledge the gorilla in the room.
In 2018, Goodman Group (ASX:GMG) accounted for 14.2% of the AREIT 300 index, second only to Scentre Group (SCG) at 18.2%. At 31 December 2023, that figure had risen to 31.2%. By the end of this reporting season, it was 34.9%, significantly larger than Scentre Group, now the second largest at 10.9%. No single stock has ever dominated the AREIT index to this extent.
As a leading owner, manager and developer of logistics real estate exiting the pandemic and now able to activate a data centre pipeline in the tens of billions, GMG has never been in a sweeter spot. It is also retaining every dollar of cash to reinvest into new projects, which is why the stock offered a measly distribution yield of 0.96% . Distributions per unit have not increased in six years and the payout ratio this financial year is likely to again be less than 30%.
With less than 25% of its earnings from traditional rent collection (the remainder come from development and funds management), Goodman is an AREIT in name only. In addition, over 60% of its earnings originate offshore. The returns have been wonderful but the risks associated with development activities of this scale, intensity and specialisation do not speak to the conservatively managed, reliable income for which the AREIT sector is known.
Goodman is the gorilla in the index. The stock rose 16.8% in February alone and produced a 12-month total return of 52.6%. Without it, the returns from the AREIT index would look very different. The consequences of further equity-like returns are likely to have a detrimental impact on the AREIT sector, to say nothing of the stock concentration risk, now at its highest level ever. AREIT investors looking at index figures should bear this in mind.
3. Operating results (largely) encouraging
Whilst the headline results were impressive, in terms of our portfolios we’re more interested in operating results. With that in mind, let’s review each sector in turn:
Industrial - Centuria Industrial REIT (ASX:CIP) is an excellent example of how industrial REITs are benefiting from strong rental income offsetting the negative valuation effects of increasing investment yields. With 87% of CIP’s portfolio located in areas like Sydney, Melbourne and Brisbane, vacancy rates remain extremely low. CIP increased its re-leasing spread (the difference between rent on expiring and re-let premises) by 51% in HY24.
While CIP was a leader in reported re-leasing spread, the sector average across was 23%, up from 15% . The industrial landlord’s ability to drive income growth was evident across the board as like-for-like net operating income (NOI) growth accelerated (see chart). This highlights the sector’s strength and corresponding popularity with investors.
Source: Macquarie Research, DXAM
Retail - This reporting period offered evidence of a return to form in a sector particularly hurt through the pandemic. Results from Scentre Group, operator of Westfield-branded shopping centres, showed tenant sales growth of 6.4%, supporting like-for-like net property income (NPI) growth of 8.8%. While rental growth outpaced that of tenant sales, retail trade volume in 2023 was up 13.6% compared to the pre-pandemic period in 2019.
As for specialty retailers, the tenant occupancy cost ratio of 16.7% remains below the 18.0% reported in 2019, suggesting further rent payment capacity and NOI growth potential. Trends in re-leasing spreads were also encouraging (see below chart). Retail is back.
Source: Macquarie Research, DXAM
Office – Unlike retail and industrial, the outlook for the office sector remains challenged. Cyclical headwinds and the uncertain implications of work-from-home have investors worried about their impact on cashflows. The persistent, elevated levels of vacancy across the major markets of Sydney and Melbourne have resulted in substantial incentives to secure tenants. This speaks to the sector’s difficulties. Asset values declined on average around 5.7% through HY24, with cap rates increasing 30bps to 5.5%. They are anticipated to soften further.
Higher quality office assets with capable management offer the sector some respite. These are faring far better than less attractive spaces, as demonstrated by occupancy rates. On average, Office AREIT portfolios are 93.9% occupied while the national CBD occupancy is at a 28-year high of 15% . Overall, CBD Office REIT occupancy rates were generally flat (see chart). This was a good result that surprised pundits. As for lease expiry over the next two years, it looks manageable for most, although there are some pockets of risk within select REIT portfolios.
Source: Macquarie Research, DXAM
4. Debt costs rising, impacts will vary
This half year, AREIT gearing increased 140bps to 21.3% while look-through gearing was up 170bps to 28.8% . Other balance sheet and interest servicing metrics, including interest coverage and net debt/EBITDA ratios, also increased. This was due to the sharp rise in debt costs. With covenant levels at around 50-55%, average debt term to maturity of 4.4 years and hedge coverage of 4.0 years , the sector is not facing any widespread problems from rising interest cost. Debt levels and interest rate exposures are generally well managed.
Rising interest costs have, however, contributed to a significant slowing in sector bottom-line earnings growth in recent periods. Although HY24 results and FY24 guidance were afflicted by the persistence of higher rates compared to prior years, earnings guidance at this halfway point was generally maintained and, in some cases, increased.
That said, some REITs are better placed than others to deal with the changed conditions. Those that have not managed their capital positions well may find their ability to take advantage of earnings and value accretive investment opportunities hamstrung.
Our interactions with REIT management teams suggests the marginal, all-in cost of new debt is around 5.5-6.0% but the weighted average cost of debt (WACD) is 3.5-5.5%. Those AREITs with a higher WACD closer to the incremental cost of new borrowings will face less of an earnings headwind as lower cost borrowing facilities require refinancing or cheaper interest rate hedges expire.
While the interest rate tightening cycle appears closer to the end than the beginning, the timing of interest rate cuts might elongate the impact of rising interest costs. In the same way that balance sheets may restrict some AREITs from opportunistic acquisitions, some AREITs will benefit more than others as interest rates begin to fall.
Across the sector, an assessment of AREIT balance sheets and the subsequent implications remains critical. This is a key part of our investment process and remains as important as ever.
5. Opportunity in the shift in focus from rates rises to operating performance
It has been more than three months since the Reserve Bank last raised the cash rate. With clear signs that inflation has peaked, the most likely next move in rates is unlikely to be up. We think this will cause REIT investors to switch their focus away from interest rates and towards AREIT operating performance. This should be a good thing for the sector. The rate tightening cycle crimped the feasibility of new development. With long lead times for the delivery of new commercial buildings, this period has likely served to restrict future supply. This should benefit existing REIT investors in the longer term.
Meanwhile, this largely positive reporting period indicates that the supply/demand tension in commercial real estate offers an opportunity. Future rent increases and a corresponding rise in underlying earnings growth at a level sustainably above CPI are a real possibility. This has yet to be incorporated in AREIT prices. While increased finance costs have indeed eaten into AREIT income statements this has been largely offset by the relative lag in top line rental indexation and market rental growth. As the rate cycle turns, we expect improved conditions for valuations and earnings within the sector.
In the meantime, opportunities abound for an active manager like ourselves and we are currently capitalising on the discounts implied by select AREIT share prices compared to our assessment of fair value. The Dexus AREIT Fund currently provides investors with a running yield of 6.0% plus compelling opportunities for future share price growth for long term investors. The quality of this reporting season only strengthens this argument.
Find out more about the Dexus AREIT Fund.
If you have any questions and are an investor or looking to invest, please contact Dexus Investor Services at dexus@boardroomlimited.com.au or 1300 374 029. If you are an Adviser, get in touch with a distribution team member in your state.
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