Pros & Cons Of Discounted A-REITs

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Historically defensive yield-plays, REITs have suffered a volatile year due to interest rate uncertainty and economic challenges. But is there now light at the end of the tunnel?

-A-REITs have underperformed the market
-Bond market volatility has fuelled REIT volatility
-Challenges remain for office
-Residential poised to bounce
-Broker preferences

By Greg Peel

In the month of June, Australian-listed real estate investment trusts (REIT) delivered a flat return, underperforming the ASX200 by -1.9%. Year to date, REITs have outperformed by 7%. June brought the surprisingly strong May CPI print, which upended both the bond and stock markets.

That 7% is misleading as it includes a 38% gain for the largest REIT, Goodman Group ((GMG)). While Goodman is indeed a REIT, and a property fund manager, its alignment with the AI thematic through its development/management of data centres has turned it into an AI story, more so than a real estate story.

Ex-Goodman, the REIT sector is down -4% year to date, and large-cap REITs are down -8%.

The Australian ten-year bond yield, the benchmark against which REIT returns are measured, began 2024 under 4%. Expectations were high in the US that the Federal Reserve was about to embark on a rate cutting cycle and it was assumed the RBA would eventually follow suit.

But 2024 has since proven volatile in that regard with sticky inflation eroding rate cut hopes (Aussie ten-year 4.6% in April). Back then a generally weakening inflation trend was leading economists to predict the first RBA cut as soon as August (yield down to 4.1%). The May CPI represented the first actual uptick in the inflation trend, and today the yield is around 4.35% (equivalent to the RBA cash rate). The market is now pricing a 50/50 chance of another RBA rate hike by year’s end.

Bond yield volatility has led to share price volatility for the historically defensive, plodding REIT sector, typically bought for yield rather than growth.

The question now is: have REIT valuations fallen far enough?

The Bad and the Good

With another rate increase now expected, UBS suggests the sector needs to confront several challenges.

Excluding Goodman Group, UBS notes growth into FY25-26 is muted, due to dilutive asset sales and higher debt costs. Generating outperformance through development/funds management has become more challenging.

The dividend yield spread to bond yields is -114 basis points below long term averages (ex Goodman). UBS sees very stretched valuations for names with growth, such as Goodman and HMC Capital ((HMC)), versus the rest, for which catalysts are lacking, with high office vacancy and logistics/retail slowing after a period of strength.

Yet, having hosted some of Australia’s leading real estate companies (listed and unlisted) at its annual property conference, Barrenjoey learned globally a significant amount of capital is sitting on the sidelines waiting to deploy, and institutions are typically underweight real estate versus their target allocations.

Australian superfunds have strong equity inflow projections, and the government’s Your Super Your Future legislation (2020-21 budget), which requires APRA to conduct an annual performance test for MySuper products and other prescribed products, implies continued investment in traditional and alternative real estate sectors.

The tremendous drop in cap rates is still unwinding and Australia has been slower to reprice than the US and Europe. Independent valuations could take another 6-12 months to fully adjust, Barrenjoey learned, and cap rates will expand by another 50-60 basis points to average 6%.

The capitalisation (cap) rate is annual rental income produced by a real estate asset divided by its current market value.

The Outlook

Jarden is forecasting 40-60bps of cap rate expansion.

Jarden acknowledges rates are likely to remain higher for longer and the August results season is unlikely to be a major catalyst for most REITs, but weighted-average funds from operations (earnings) growth is starting to improve. At an implied -15% decline in gross asset value for the passive REITs, Jarden believes the downside risk to asset values is well reflected in current valuations and a growing number of REITs is moving from defence to offence.

Overall, the broker sees 18% upside to its 12-month REIT target prices (ex Goodman) and suggests sector risk-reward is looking more attractive.

Also acknowledging the backdrop of higher rates, UBS sees several positives.

Asset values are closer to the trough, with transactions gradually resuming. Debt markets are improving. The consumer has remained resilient, albeit slowing.

UBS sees less supply and pockets of growth (data centres, manufactured housing estates), and most valuation metrics are supportive. In a period of sticky inflation, the broker has a preference for value REITs with high quality assets and only seeks cyclical earnings/growth where it sees suitably low market expectations.

The Office Question

The covid lockdowns proved that office workers could successfully work from home without a loss of productivity, giving rise to the assumption that forever after, hybrid work-from-office/work-from-home models would be adopted. This would result in a downsizing of corporate office space requirements, and thus a decline in demand for office blocks.

Which to an extent has come to pass, reducing office asset valuations. But while some CEOs have embraced the hybrid model, others are beginning to demand a full return to the office.

Office market sentiment has become marginally more positive in recent weeks, Jarden notes. While listed office portfolios faced further negative reversions in their latest valuation announcements, adopted cap rates are starting to look more realistic to Jarden, supported by a broadening basket of transaction (office sales) evidence. In addition, while overall office market vacancy rates remain high, the broker saw evidence of positive leasing momentum within new developments under construction across both the Sydney and Melbourne CBDs.

Jarden’s analysis demonstrates 68% of assets under construction have now been leased, with assets in the core Sydney CBD showing occupancy rates of 80-95%. With assets under construction leasing steadily, and potentially no further assets being delivered within the core this decade, the broker sees the risk of a supply shortage within the core CBD in the next five years.

There is a debate in the market over the potential and timing of an office recovery, Citi has found. A survey of investors revealed 62% believe office-exposed REITs have reached an inflection point. The positive response is reflective of a potential improvement in investor sentiment towards the sub-sector.

Although transaction activity is showing sign of improvement, Citi remains cautious on underlying fundamentals and cash flow pressure of high office lease incentives and vacancy.

The office rent growth outlook is not great, declares Morgan Stanley. Sydney/Melbourne CBD rent growth has tracked at 2.8% per year since 2020, and real estate agents expect it to run at 3% per year to 2027, versus 5% per year in 2000-20. Given the lower income growth outlook, there are reasons to think, Morgan Stanley suggests, the cap rate spread should be higher than the long-term average in the foreseeable future.

Preferences

Goodman Group is still the best quality stock in the sector, Jarden insists, and the broker would not find a lot of disagreement. But while it is hard to ignore 10-15% annual growth, the shares are up 82% in the past twelve months and 46% in the past six months.

Goodman remains well underpinned going into a tough August results season but, as investors become more positive on the value names in the sector, Goodman could become a funding source for rotation into beaten-down areas of the sector.

Jarden has downgraded Goodman to Sell from Neutral.

UBS sees very strong growth from Goodman’s data centre strategy but also moves to Sell from Neutral on valuation grounds and high investor expectations.

Industrial cap rates are rather tight for where bond yields are now, Morgan Stanley admits, when compared to the typical relationship. However, industrial market rent growth should track at 4.4% per year in 2023-27, more than double the 2% compound annual growth rate in 2000-18.

Given lower asset valuation risks, Morgan Stanley prefers industrial-exposed REITs over office-biased REITs, and that includes Goodman Group, for which the broker retains an Overweight rating.

Also holding Buy or equivalent ratings on Goodman along with Morgan Stanley are Macquarie and Citi. Ord Minnett leans to the negative side with a Lighten rating.

Further to Goodman, Morgan Stanley also prefers industrial-exposed Stockland ((SGP)), Centuria Industrial REIT ((CIP)) and GPT Group ((GPT)) over office-biased Dexus ((DXS)), Centuria Office REIT ((COF)) and Mirvac Group ((MGR)).

Jarden is becoming more constructive on deep value diversified REITs, upgrading GPT Group and Mirvac to Overweight and Dexus to Neutral after significant weakness in the past six months. All three are now trading at discounts to the sum of their parts, even if the broker struggles to see near-term catalysts.

GPT is arguably best positioned, Jarden argues, with retail, logistics and funds management performing well. Mirvac’s re-rating relies mainly on a residential recovery, while Dexus’ exposure to office and funds management probably means it will take longest to turn around.

UBS upgrades Mirvac to Buy following underperformance with earnings growth emerging post FY25, and upgrades Lendlease ((LLC)) and Vicinity Centres ((VCX)) to Neutral from Sell. This broker’s most preferred names are Dexus, Mirvac and Region Group ((RGN)) while its least preferred names are Scentre Group ((SCG)), Goodman, and Centuria Capital ((CNI)).

Which segues us towards property fund managers. Jarden is concerned consensus expectations for Centuria Capital’s FY25 earnings look too high given pressure on asset values and assets under management.

Charter Hall ((CHC)) looks best value to Jarden but in the absence of a pick-up in transaction activity, the broker believes earnings momentum in FY25 remains sluggish. HMC Capital is seeing strong momentum but Jarden expects underlying cash earnings momentum to take time to follow. After the share price rally, Jarden believes the shares are pricing in a lot of that earnings upside potential.

Housing

Don’t mention the housing crisis.

Macquarie’s recent HomeBuilder survey found that, despite incrementally positive feedback, builders are cautious about a material rebound in sales until there is clarity on RBA cash rate cuts. 50% of builders have experienced an increase in sales over the past three months, although most are cautious over the coming three months.

Macquarie’s Macro Strategy team expects -75bps of RBA rate cuts over 2025, beginning in the March quarter, which should support the sector.

Mirvac’s and Stockland’s residential activity remains sluggish, however, longer-term sector fundamentals remain positive, in the broker’s view. This is due to the supply/demand imbalance, strong population growth, tight rental markets, and the potential for government stimulus.

Macquarie believes Mirvac has the potential for one of the largest re-rates across the sector as rate cut timing becomes more certain. The broker’s prior analysis has also indicated residential stock multiples have historically troughed 6-8 months prior to a shift in monetary policy to an easing stance.

While sales and settlement momentum in residential is still weak and unlikely to improve in the near term, Jarden also believes sentiment will change quickly when RBA cuts become likely. Stockland is the broker’s top pick, as it believes the REIT’s strategy sets it up for superior earnings growth and returns, despite trading at a discount to the sector.

Landlease communities remain structurally attractive and Jarden believes Lifestyle Communities’ ((LIC)) recent weakness now looks overdone, while both Lifestyle Communities and Ingenia Communities ((INA)) should see strong growth. Reader take note: this view was expressed before Lifestyle Communities became the subject of a Four Corners’ deep dive into alleged malpractices throughout the landlease industry, targeting Lifestyle Communities in particular.

Jarden upgrades Mirvac to Overweight after recent underperformance but sees fewer near term catalysts than for the other residential names.

And Another Thing

Jarden’s preference in passive REITs remains for stocks with the best top-line momentum. National Storage REIT ((NSR)) should benefit from structural storage demand drivers, ramping up its non-stabilised portfolio and inorganic growth.

Mall REITs Vicinity Centres and Scentre Group continue to see a better-than-feared leasing environment, Jarden notes, with additional upside from medium-term development growth and asset recycling.

Strong demand and low supply in logistics (Centuria Industrial REIT) and childcare (Arena REIT (ARF))) should drive strong growth. Ongoing weakness in non-discretionary retailers (Region Group, Charter Hall Retail REIT ((CQR)) and HomeCo Daily Needs REIT ((HDN))) looks overdone to Jarden against steady growth.

UBS has downgraded Arena REIT and BWP Trust ((BWP)) to Neutral from Buy.

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