Post Bottom, Focus Shifts To A-REITs Potential

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After a long period of post-covid underperformance, analysts believe we are at or near a trough for the listed real estate sector.

-Cap rates up and valuations down in REIT sector
-Recent outperformance in falling market
-Transaction activity picking up
-Analysts calling the trough

By Greg Peel

In the two and a half years to December 2024, listed real estate investment trusts (REIT) have expanded their cap rates by 47-140 basis points depending on asset class, while valuations have declined as much as -26% in Office. Morgan Stanley thinks the revaluation cycle has bottomed, and this could be a timely period for equity investors to consider the Real Estate sector.

In simple terms, the capitalisation or cap rate is the ratio of net income on a property (rent less expenses) divided by the current value of that property. It is not a black-and-white measure, as while a higher cap rate appears on the surface to be good, if it reflects a weaker property valuation rather than rising rent, it is not so good. Just as a high dividend yield may result from a falling share price.

Typically, high cap rates are considered a concern, reflected in weakness in the REIT sector over the past high inflation, high interest rate period.

The Australian REIT sector weakened -4.2% in February, over the result season period. But there are two caveats. Firstly, the market in general suffered a Trump-led downdraught, and secondly if we remove Goodman Group ((GMG)) which has by far the biggest market cap in the sector, daylight second the REIT sector actually rose 0.6%, Jarden notes.

But volatility was excessive within the sector (as it was elsewhere too). Of the listed REITs under Jarden’s coverage, fifteen saw share price moves over the month of more than 5%. Many share price reactions far exceeded changes to earnings forecasts following results, Jarden notes.

The ongoing market sell-off had REITs down -2.7% in the first week of March, but the sector outperformed the ASX200 by 80bps. As stock markets sell off here and in the US, there has been a flight to safety into bonds, pushing down yields. This has eased the pressure REITs have suffered ever since the post-covid inflation surge.

Trough?

One of the key concerns in A-REITs since mid-2022 has been cap rate expansion and associated decline in asset valuations, Morgan Stanley notes, especially on the back of rate hikes and ten-year bond yield escalations. This broker believes it is under-appreciated that in the stocks under its coverage, Industrial cap rates have expanded 140bps since June 2022, Office valuations have declined -26% since June 2022, and all Retail portfolios resumed positive revaluations in the December 2024 half.

As physical valuations start to recover, investors may see improved relevance of the price to net tangible asset (NTA) valuation multiple for asset-heavy REITs, Morgan Stanley suggests. Value-biased investors could see attraction in stocks trading at discounts to NTAs.

But investors should take note as stocks currently trading at the greatest discounts are those that have the greatest fundamental cash earnings concerns. The broker singles out Dexus ((DXS)) and Centuria Office REIT ((COF)) due to Office incentives, and HealthCo Healthcare & Wellness REIT ((HCW)) due to Healthscope uncertainty.

There are growing signs we are at or close to a trough in NTA and adjusted funds from operations (AFFO), Jarden notes. With the first rate cut occurring during the earnings season, it was no surprise all REITs flagged a more constructive outlook for earnings and NTA going forward. Jarden agrees cap rate expansion is largely behind us, which should drive NTA growth.

The outlook for AFFO depends a little on how close individual REITs are to the marginal cost of debt but Jarden suggests the growth profile for the sector is improving, and earnings per share (EPS) growth should exceed earnings before interest and tax (EBIT) growth from FY27 onwards.

More REITs are trying to move from playing defence to playing offence and, based on Jarden’s forecasts, earnings momentum should improve from here. However, there is still a strong divergence in REITs’ abilities to do so.

Given the dominance of Goodman Group in the sector, both in terms of market cap weight and growth expectations, Jarden has analysed growth potential for the sector both with and without Goodman. Analysis suggests, assuming the bank bill swap (funding cost benchmark) futures curve does not move up from here, the earnings outlook has reached a trough and should accelerate further from FY25 onwards, and headwinds from rising weighted average cost of debt should slowly diminish.

Office

The hardest hit segment of the REIT sector in recent years has been Office. A combination of covid lockdowns leading to requisite rent relief, the subsequent work-from-home trend reducing office space demand, and rising interest rates in the post-covid inflation boom have hit the segment hard.

Asset values in Australia have troughed in Morgan Stanley’s view, and Office is at or near a trough. As a result, property fund managers, which have been hampered in the last two-three years by increased gearing, valuation uncertainty and slower funds inflows, are likely to have better momentum in 2025.

Morgan Stanley has identified the patterns of buyers of the $70bn-odd of Office transactions in Australia from 2019-24 and believes we could be at the start of a period in which capital inflows into Australian commercial real estate will ramp up.

Office capital flows are insightful to track, the broker suggests, given it has traditionally been the most liquid sector. 2019 saw $23bn of assets transacted; the largest in a single sector in a year. The number dropped down to just $5.2bn in 2023.

2024 saw a recovery $9bn of deals, which was mostly driven by opportunistic offshore buyers, Morgan Stanley notes, in particular Asia-based groups. This volatility, against a backdrop of around -20-25% asset devaluations over the past two-three years, means that Office is perhaps the bellwether for confidence and funds flows into Australian properties.

Property Fund Managers

Jarden has updated its analysis of asset under management (AUM) growth for REIT fund managers following the December half results to assess what is currently priced in by consensus. AUM growth is still under some pressure from negative revaluations and asset disposals, the broker notes, although the long anticipated pick-up in transaction activity is starting to emerge and Jarden believes future acquisition opportunities should drive an ongoing re-rating across the group.

Jarden finds it interesting to see the significant valuation discrepancy between dedicated listed REIT fund managers. Goodman Group (which is also a fund manager) and HMC Capital ((HMC)) continue to trade at premiums, but this has reduced somewhat following recent underperformance. Despite strong outperformance year to date, Charter Hall Group ((CHC)) looks the most attractive to Jarden from a valuation point of view, given a strong track record of assets under management (AUM) growth in the previous cycle.

Over the five-year period to December 2024, fund managers Goodman Group, Charter Hall, GPT Group ((GPT)) and Centuria Capital Group ((CNI)) combined have added $86.7bn of AUM, at a compound annual growth rate of 14.2%, to reach an aggregate total of $178.6bn of AUM. The rate of AUM growth clearly declined through FY23-24, driven mainly by negative revaluations and a slowdown in transaction activity.

Jarden feels the sector is at or close to the trough in asset valuations, and has factored this theme, together with an improvement in transaction and development activity, within its outlook for the sector. Over the next three years to December 2027, Jarden forecasts AUM across this group of fund managers will grow 40% at a CAGR of 11.9%.

Jarden has not yet captured HMC Capital and Dexus in its historical analysis due to inconsistent history, but adding these entities contributes a further $26.4bn of forecast incremental AUM over the next three years to December 27, driven primarily by HMC Capital’s strong growth targets.

As asset values and cap rates improve, this should be followed by escalation in transaction volumes, Morgans Stanley suggests, and therefore an uplift in fees and AUM for companies that facilitate capital flows. Charter Hall remains this broker’s preferred exposure for investors seeking earnings leverage to asset valuation and uplift in transaction volumes.

In the small cap space, Morgan Stanley’s preference is for Centuria Capital. Both REITs are looking to launch new products by the end of 2025 to capitalise on the bottom of cycle, with Charter Hall looking at a Convenience Retail, and a Diversified fund, while Centuria is planning two new listed REITs.

The Wider Sector

Citi hosted a group of Australian listed corporates, and met with both investors and global peers discussing key trends in global real estate fundamentals.

The conclusion was Australian real estate is benefitting from GDP and consumer spending growth, underpinned by immigration and underlying consumer resilience. This, together with reducing or limited development supply across various property sub-sectors, is creating improving fundamentals.

Retail is benefitting with high occupancies, escalation momentum and positive leasing spreads, participants noted. Industrial remains attractive given low vacancy and development discipline with limited speculative development.

Office has been the laggard sector in recent years, but management teams seem more confident we are at or close to the bottom in fundamentals, with the potential for improvement moving forward. Residential continues to benefit from significant under-supply of housing in major cities.

As noted, Goodman Group is both the biggest stock in the REIT sector and was the biggest drag over February. From late January to early March, the stock has lost -30%. Some might opine, Goodman shares had arguably become overvalued and overcrowded, driven by the global AI frenzy.

Goodman falls into the Industrial segment and, in recent times, the Logistics sub-sector, which rode a boom in distribution centres required for the rise of online retail. Then it moved into data centres, which were already seeing growing demand before AI suddenly appeared.

Citi’s conference found data centre development at attractive yields on cost is a key theme across listed real estate. The recent interest rate cut is expected to improve finance costs and valuations with stabilising cap rates.

Amidst the positivity there was nevertheless recognition there are still REIT headwinds from high construction costs, operational cost inflation and differing property taxes across various states. Citi concludes investors were generally positive on underlying fundamentals, but cautious on macro environment uncertainty and implications of global tariffs.

Funds management remains a key theme to create asset-light earnings growth with companies pursuing differing strategies differentiating themselves from competitors.

Jarden continues to like Residential and prefers Stockland ((SGP)) and Ingenia Communities Group ((INA)) but believes Mirvac Group ((MGR)) should see a strong earnings trajectory as well beyond FY25. Lifestyle Communities ((LIC)) is starting to look oversold, Jarden suggests, but may take longer to recover.

Jarden prefers Vicinity Centres ((VCX)) over Scentre Group ((SCG)) in retail malls. The broker thinks weakness in Goodman is overdone, and also believes Charter Hall offers the most earnings recovery among fund managers.

In passive REITs, Jarden suggests weakness in Arena REIT ((ARF)), National Storage REIT ((NSR)) and Region Group ((RGN)) is creating opportunities assuming management teams at these REITs can continue to execute.

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