The upcoming profit reporting season for listed real estate investment trusts (REITs) is shaping up as an acid test of how the sector is coping with ratcheting interest rates and rising vacancies if the economy slows as expected.
REITs are exposed intrinsically to rising bond yields and are often described as a listed proxy to debt market movements.
So far this calendar year the ASX200 REIT sector has fallen 20 per cent, double the decline of the broader stock market.
But property watchers say higher interest rates and higher inflation do not necessarily bode poorly for the sector – at least for REITs that can increase rents at a faster pace than financial and labour costs.
In a sector review, broker Wilson says, “We believe the REIT sector’s underperformance should be coming to an end, given that bond yields have started to stabilise and valuations are generally supportive.”
Macquarie Equities has factored in sector-wide 17.5 per cent earnings per share (EPS) growth for the year to June 2022, abating to 8.1 per cent in the (current) 2022-23 year and 6.1 per cent in 2023-24.
The firm notes this is a far cry from the earnings downgrades during the global financial crisis because the sector’s current leverage is much lower now.
“The key for the sector is rising yields, which is a valuation headwind and drives up interest costs.”
Broker UBS has only modestly adjusted its EPS expectations but assumes asset devaluations of about 8 per cent for the REIT fund managers, amid “more severe” conditionals for the residential-focused REITs such as Mirvac and Stockland.
While the sector’s average gearing ratio is a manageable 21 per cent, UBS says more attention will be paid to measures such as interest coverage ratios.
S&P Global Ratings senior director for global ratings Craig Parker said Australian REITs were “attuned” to the rising cost of debt and as a result had a high proportion of fixed financing and a “smooth” debt maturity profile.
But he said while industrial assets were holding up well, all REIT sectors “have their challenges in a rising interest rates environment”. CBD retailers continue to struggle, while CBD office landlords have been forced to offer “sizeable” tenant incentives.
Wilsons warns that “structural issues” within office and retail REITs are likely to be exacerbated by an economic slowdown, “our preference is to invest in sectors with structural tailwinds and defensive earnings, such as logistics and healthcare REITs”.
Still, the mounting headwinds are yet to be reflected in the leading REITs’ outlook statements to date. Goodman Group reports ongoing “tight supply and demand” across its global, $69 billion industrial-oriented portfolio.
Scentre Group’s outgoing chief executive Peter Allen reports shopping centre occupancy of 98.7 per cent, as of the end of March.
“In light of improving conditions and strong performance of our business, earnings are expected to grow in excess of 5.3 per cent in 2022,” Allen said.
Stockland highlights continued “elevated” demand, but warns conditions are expected to moderate over the medium term “in line with rising interest rates”.
Meanwhile, Morgan Stanley property analyst Simon Chan flags the prospect of a round of share buybacks, as the well-capitalised REITs move to exploit any unjustified discounts to net asset backing.
He said while some REITs have heavily promoted their project development capacity, they could add more value by buying more of their existing assets on the cheap.
“Six major REITs have come off to the point where they are trading at a 15 per cent discount to their gross book value on a [deleveraged] basis,” he says.
Quay Global Investors concurs the valuation of REITs now implies their assets are valued at below replacement cost, which deters developers from introducing new supply into an already undersupplied market.
“Excess demand relative to constrained supply drives up rents and values until the development cycle can begin again – where prices are above replacement cost,” says portfolio manager Chris Bedingfield.