SMSFundamentals: A Comprehensive Guide To Australian REIT Investing

This story features GOODMAN GROUP, and other companies. For more info SHARE ANALYSIS: GMG

SMSFundamentals is an ongoing feature series dedicated to providing SMSF trustees with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

For an introduction and story archive please visit FNArena's SMSFundamentals section on the website.

A Comprehensive Guide To Australian REIT Investing

Australian Real Estate Investment Trusts (A-REITs) have emerged as a compelling avenue for investors seeking regular streams of income with exposure to the real estate market without the complexities of physical property ownership. FNArena's guide delves into the vital mechanics of A-REITs. 

-A-REITs offer exposure to real estate assets, including through rent income and asset appreciation
-Pros include diversification, liquidity, and regular income, while cons involve market volatility and sensitivity to economic cycles
–Investors should assess a REIT's property portfolio, financial performance, dividend history, market and economic factors, risk assessment, and growth strategies before investing
–Effective debt management is crucial in evaluating the quality of A-REIT

By Anuj Sharma 

What is an A-REIT?

An A-REIT, or Australian Real Estate Investment Trust, is an economic entity (a 'trust') that has a portfolio of real estate assets that provides shareholders with exposure to income-generating properties (mostly through rent).

Emerged in 1971 in Australia, specific examples are Goodman Group ((GMG)), a prominent commercial and industrial REIT (owner and developer of warehouses and logistics and data centres), and Scentre Group ((SCG)), which owns and manages a shopping centres-oriented portfolio.

Source: Goodman FY23 Results presentation.

What is REIT investing?

REIT investing involves acquiring shares or units in A-REITs, A-REIT-focused ETFs, or simply replicating a benchmark index (like S&P/ASX200 A-REIT) to gain exposure to the Australian or global real estate market without owning properties physically.

Investors, in this case, become shareholders in the A-REIT or fund and receive dividends (or more precise: distributions) based on the rental income generated by the property portfolio.

For instance, Stockland Group ((SGP)) focuses on a diverse range of properties to obtain sector diversification. Investors can invest in the trust and potentially benefit from the growing demand for logistics properties driven by e-commerce, global supply chains, and economic growth, earning a share of the rental income plus capital appreciation.

Source: Stockland 1Q24 Market update

Pros and Cons of REIT Investing

Investors considering REIT investments should weigh the pros and cons:

Pros:

-Diversification: REITs provide diversification across various property types, like commercial, residential, and industrial, reducing risk compared to direct property ownership. Fundamentally, the diversification allows investors to access a broad range of real estate assets without making an effort at property management.

-Liquidity: REITs are traded on stock exchanges, offering ease of buying and selling, unlike physical properties.

-Income Stream: Investors receive regular income through distributions, as REITs are required to distribute a significant portion (at least 90%) of their earnings.

-Transparency: Publicly traded REITs offer transparency through financial reporting and regulatory oversight.

Cons:

-Market Volatility: REIT prices are sensitive to market sentiment and bond yield and interest rate changes, which can lead to significant price fluctuations. This has been the case over the past two calendar years as central banks worldwide hiked interest rates, causing bond yields to rise sharply from extraordinary low levels during the covid-pandemic. Higher bond yields reduce asset valuations, all else remaining equal.

-Lack of Control: Investors have no say in the management decisions or property choices made by the REIT.

-Tax Considerations: Tax implications, such as capital gains and potentially complex distributions, should be understood. For instance, A-REITs pay out distributions (similar but strictly taken not equal to dividends) that have not been taxed at the trust level, and thus there are no franking credits attached.

-Market Cyclicality: REITs are affected by property market cycles, and economic downturns can impact rental income and property values.

A specific example for investors is the S&P/ASX200 A-REIT index, which represents Australia’s listed REIT sector on the ASX. Rapid interest rate hikes by the RBA (to pull the trend in inflation back inside the 2%-3% target) didn’t impact the rental income flow of A-REITs, but the sector's heavy debt burden led the index to fall in negative correlation with higher debt servicing costs, asset devaluations and mortgage rate trends, illustrating the potential downsides of REIT investing.

Source: tradingview.com (as of October 31, 2023)

Types of REITs

Investors have a diverse range of A-REITs to choose from, each with their own unique characteristics and investment opportunities. Although diversified REITs dominate the space, here are three prominent types of A-REITs:

Retail REITs:

Retail REITs invest in shopping centres and in commercial property, providing investors with exposure to the retail property sector. A specific example is Scentre Group, which owns and operates Westfield shopping centres across Australia and New Zealand.

Retail REITs are appealing to investors looking for stable rental income, often backed by long-term leases with retail tenants. These properties typically generate consistent cash flows. However, they can be sensitive to economic conditions and shifting retail trends, like the growth of e-commerce.

The covid-19 pandemic, for instance, highlighted the challenges faced by retail REITs due to lockdowns and changing consumer behaviour. In 2023, investors are worried about the impact from RBA rate hikes on household budgets and thus on the outlook for consumer spending.

Office REITs:

Office REITs, such as Dexus ((DXS)), focus on commercial office properties. Australia's major cities, particularly Sydney and Melbourne, offer robust office markets.

Investors in office REITs benefit from the rental income generated by leasing office spaces to businesses. These properties are often located in prime central business districts and can provide steady income.

However, occupancy and demand for office space are influenced by economic cycles, business expansions, etc. The rise of remote work and flexible office solutions post-pandemic may impact the performance of office REITs as office space requirements evolve.

Industrial REITs:

Industrial REITs, with Goodman being a notable example, concentrate on logistics and industrial properties. The e-commerce boom and the need for efficient supply chain management have driven growth in this sector.

Investors in industrial REITs can benefit from strong rental income derived from warehouses and distribution centres. These properties have been in high demand. The usual warning is that investors should be aware of the cyclical nature of the industrial sector, which is closely tied to economic conditions and fluctuations in global trade.

This time around, however, the sector is supported by notable megatrends, such as e-commerce and cloud computing, which makes Goodman Group, for example, a major beneficiary of the growing demand for data centres.

Source: ASX A-REIT Update (September 2023)

How to Invest in REITs

Investors have several ways to invest in A-REITs, each with advantages and considerations.

Direct Stock Investment:

One straightforward method is to purchase A-REIT shares through a brokerage account. It provides direct ownership and flexibility in trading. It also requires research and active management and can lead to concentrated exposure to a single REIT.

Exchange-Traded Funds (ETFs):

Australian property ETFs like the Vanguard Australian Property Securities Index ETF ((VAP)) pool investments from multiple investors to buy a diversified portfolio of REITs.

Investing in A-REIT ETFs provides exposure to various REITs, reducing individual stock risk. It's a passive, cost-effective approach suitable for investors seeking diversification, and avoiding concentration risk.

Managed Funds:

Managed funds or mutual funds like the Colonial First State Property Securities Fund invest in a mix of REITs. These funds are actively managed by professional portfolio managers. They offer diversification, professional oversight, and the potential for higher returns, but may also attract higher fees.

Real Estate Crowdfunding:

Some platforms, like BrickX, allow investors to buy "bricks" or fractional ownership in individual properties, effectively investing in real estate without directly owning REIT shares.

While it offers a unique approach to real estate investing, it might not provide the same level of diversification as traditional REITs.

Source: BrickX

Property Syndicates:

These involve pooling funds with other investors to buy specific properties. While this provides direct property ownership, pooling typically requires a significant upfront investment and involves active property management.

Listed Investment Companies (LICs):

LICs like the Mirvac Property Trust ((MPT)) offer another way to invest in a diversified portfolio of real estate assets. These LICs can trade on the stock exchange, similar to REITs.

Generating Profits through REIT Investing:

Regular 'income' payments

REITs are known for their consistent distribution payments. Centuria Office ((COF)), for instance, distributes 95% (payout ratio) of its rental income to shareholders.

Investors can profit by holding REIT shares and receiving regular cash flow. The yield, often higher than with other stocks, can provide income for reinvestment.

Source: Centuria Office REIT distributions

Capital Appreciation

As the value of underlying real estate properties appreciates, the share prices of REITs may also rise. Investors can profit through capital gains when selling shares at a higher price than the purchase price.

Goodman Group, for example, benefits from high occupancy and positive rental growth, but also from funds management and new project developments.

Source: tradingview.com (as of October 31, 2023)

Profits can also be tied to broader economic trends. For instance, Scentre Group's value growth may be influenced by consumer spending and economic conditions. As the economy grows, retail REITs can experience increased tenant demand and rising rental income.

Methods of Assessing REITs Before Investing

Assessing REITs before investing is crucial for investors, and it requires a thorough evaluation of various factors. We're using Goodman and Scentre as examples to examine the key methods for assessing REITs:

Property portfolio analysis:

Examine the quality, location, and diversification of the REIT's property holdings. In the case of Goodman, assess the locations and types of industrial properties, their occupancy rates, and the quality of tenants. Evaluate the potential for rental income and property value appreciation.

Source: Goodman FY23 Results presentation

Financial Performance:

Review financial metrics, including Funds From Operations (FFO), net asset value (NAV), and debt levels. This analysis provides insights into the REIT's financial health. For Scentre, understanding its FFO growth and NAV helps gauge its financial strength.

Source: Scentre Group Half-Year Results Presentation

Dividend Yield and History:

Evaluate the REIT's yield and its history of payments. For investors seeking income, consistent and growing distributions are vital. Assess whether the yield is competitive and sustainable based on the REIT's cash flow and payout ratio.

Source: Simply Wall St

Market and Economic Factors:

Consider the current and anticipated market conditions, economic trends, and industry-specific factors. Analyse how external forces can impact the REIT's performance. For instance, in the context of Scentre, understanding trends in leasing agreements is crucial.

Source: Scentre Group Half-Year Results presentation

Risk Assessment:

Identify and assess risks associated with the REIT, such as interest rate sensitivity, market volatility, and economic factors.

Determine how these risks may affect rental income and property values. More specifically, how the REIT is hedging against the high-interest rate and whether it is aligned with the economic outlook.

Source: Scentre Group Half-Year Results presentation

Source: Deloitte

Growth Strategies:

Investigate the REIT's growth strategies, including plans for acquisitions, developments, and geographical expansion. For instance, in the case of Goodman, understanding its property development and portfolio growth initiatives is key.

Source: Goodman FY23 Results presentation

Performance Analysis of A-REITs

Being a leverage game, a key fundamental in evaluating the quality of REITs is not the level of debt but how effectively the REIT is managing its debt.

Having said so, the sector is globally under pressure (mostly trading at discounted values) as investors worry about the consequences of higher-for-longer interest rates and government bond yields which reduce asset values, increase the costs for servicing debt and weigh on economic activity generally.

During the inflationary environment (started in June 2020), the A-REIT sector (XPJ) was outperforming the market (ASX200); however, once interest rates started to increase (under RBA tightening), the sector underperformed the market.

Similarly, the underperformance of Scentre (+13%) against Goodman (+41%) can at least partially be explained by the decisive difference in debt-to-equity ratios.

Source: Simply Wall St

Conclusion

In conclusion, A-REITs offer a versatile and accessible means of investing in the local and the global real estate market. The sector provides diversification, liquidity, and consistent income, but investors must be mindful of market volatility, specific risks, and tax considerations.

Most importantly: A-REITs are subjected to broader economic trends as well as the rise and fall in bond yields, and financial conditions generally.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms