When comparing price to net asset values (NAV), at face value the A-REIT sector looks cheap. On average, A-REIT's are trading at a 24% discount to NAV.
However, face value does not paint the whole picture. At a headline level we believe NAVs are currently overvalued and will need to be written down. Ultimately, the impact of higher bond yields (and thus capitalisation rates) is yet to be 'fairly' reflected in the asset valuations recorded on REIT's balance sheets given the inherent lag involved in periodic portfolio revaluations. Moreover, at the sub-sector level, uncertainty around natural future demand remains a NAV overhang for certain asset classes.
Office for us stands out as the most at risk of asset write-downs over the next 12 months. We remain cautious office REITs due to:
- Bond yield-driven recalibration not over (albeit this is true for many REITs).
- Demand looks soft and vacancy rates are still increasing – working from home is structurally changing the office landscape.
- Supply increasing – projects started before COVID are getting close to completion adding supply into an already soft market.
We currently have a preference to the logistic and healthcare sectors through our holdings in Goodman Group (GMG) and Healthco (HCW). Investors should be exposed to in-demand, fast-growing sectors such as distribution warehouses, data centres, and healthcare facilities. These specialty sectors will likely exhibit the most significant pricing power, which will still give them an attractive growth profile relative to traditional sectors like office and retail. We believe the logistics sector offers the best prospects for rental growth.
Valuation Recalibration Ongoing, Keeping an Eye on Gearing Levels
Historically, A-REITs have been seen as bond proxies. However, there tends to be a lag between bond yields rising and cap rates rising as the asset revaluation process takes time. Therefore, we expect recalibration is not yet over (even if bond yields have peaked).
One of our key concerns is still the impact of asset write downs on gearing levels. Material write downs would lead to lower NAVs and higher gearing.
It is not implausible that some REITs will have to sell assets or raise capital to combat higher gearing. We think the REIT sector is unlikely to outperform in this environment.
Using a REIT sector earnings yield vs bond yield regression, the model implies the market should be 7% lower than current levels, implying that the market does not believe bond yields will remain at these levels or REIT share prices will fall further.
Bonds headwind easing
We do not want to be underweight REITs as we believe bond yields have largely stabilised and the risk is now to the downside for yields as investors contemplate recession risk (or at least a decent slowdown) and an easing of inflation pressures.
If bond yields fall this should be a tailwind for REIT valuations. Under our sensitivity analysis (fig 3), a 10-year bond of 3.5% would suggest the current REIT sector earnings yield (6.5%) is at fair value, which seems reasonable in our view. Accordingly, neutral REITs seem appropriate at a headline level.
Out of Office
The well-documented structural headwinds facing office buildings have resulted in the sub-sector trading at a discount to the broader A-REIT market, with offices earning themselves a risk-premium to account for the heightened uncertainty surrounding their long-term earnings outlook. Despite the (seemingly) attractive NAV discounts on offer, we remain structurally cautious towards office landlords with the risk/return dynamic still skewed to the downside.
Vacancies are Rising as Demand Softens
Office vacancy rates are now at their highest levels since the mid-1990’s and well above the cyclical highs seen in FY19 prior to the onset of COVID lockdowns. In most major markets, vacancy levels have ticked upwards over the past 12 months and we suspect there is likely more pain to come for landlords over the coming years due to a challenging supply/demand dynamic.
Demand Picture Challenged by New Ways of Working
From a demand perspective, despite the growing push for workers to return to the office the evidence continues to point to a permanent shift towards hybrid working environments. All else equal, this is likely to translate to a structurally lower natural level of demand for office floor space and lower net effective rents per square metre and/or higher vacancy rates.
Considering the long-dated nature of most rental agreements, with the weighted average lease term of the major ASX-listed office landlords currently being ~5-6 years, it is likely this shift is yet to be fully reflected in reported vacancy rates.
There has already been an increase in sublease space on the market compared to pre-COVID levels (albeit it has retreated from record highs in 2020/21) as corporates (particularly in the tech sector) have downsized their office footprints prior to lease expiry. In the Sydney CBD for example, June 2023 sublease space sat at ~125k sqm, compared to the long-term trend of ~60k sqm and pre-COVID highs of ~120k sqm (CBRE Australian Office Sublease Barometer). The value of incentives being offered to tenants also remains stubbornly high compared to pre-COVID levels and long-term trends.
We view persistently low levels of physical office occupancy (i.e. the proportion of employees actually working from the office) as a leading indicator that suggests vacancy rates (i.e. the proportion of floor space leased with tenants) could continue to rise over the medium-term as more leases roll off.
We are also conscious of the degree of cyclicality within the office sector amidst a slowing domestic economy, albeit a prolonged downturn with widespread job shedding is not our base case expectation.
Excess New Supply an Underappreciated Headwind
The supply side of the equation has also put significant pressure on sector fundamentals as net absorption (i.e. demand) has been far outweighed by the above-average quantum of new office completions in recent years, in addition to increased sublease space.
A number of new developments are under construction and planned to come online in the major cities over the medium-term. We expect this will continue to weigh on sector fundamentals (in aggregate), even if tenant demand is stronger than expected.
Retail REITs – Slowdown Expected
The ongoing positive trends in mall REIT's operating metrics may remain resilient despite decreased foot traffic and retail sales in 2024. For income investors, Scentre Group (SCG) is our preferred large-cap mall REIT due to its quality assets and low valuation (P/NAV of ~24%).
At this stage of the cycle, we favour mid-cap shopping centre REITs (Region Group (RGN)) because of their attractive distribution yields, fair valuations, and potential as stable investments amidst a softening consumer climate. The staple tenant mix of Coles, Woolworths, and Wesfarmers makes up 45% of the rent, a key feature we like.
Logistics – Secular Growth Sector
Australia's logistics sector has seen rental growth accelerate from high single digits (mid-teens in Sydney/Melbourne) in 2022 to 25-30% over the past 12 months, driven by record-low vacancies. Among the major global markets, the Australian market (led by Sydney) has the lowest vacancy rate (<1%). The rental growth outlook remains robust with above-trend (~4%) rent growth expected over the next 5 years per annum.
We hold a preference to Goodman Group (GMG) to benefit from the structural growth in logistics.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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