How REITs de-risk future earnings

The A-REIT sector returned -3.6% in August, giving back some of its performance from the previous month as bond yields rose 54 basis points over the month. In comparison, the Fund returned -3.3%, outperforming the benchmark by 0.3%. Key contributors to performance included our holdings in Charter Hall Group (CHC +6.0%), Peet Limited (PPC +8.1%), and Lifestyle Communities (LIC +3.1%).  CHC was one of the best performers for the month after delivering an impressive FY22 result with earnings up 90% driven by strong performance fees. Despite rising rates and investor caution, CHC has a positive outlook, reflecting: 1) transaction activity likely to exceed cautious market expectations, and 2) its ability to leverage off its strong platform for future growth.

Top Holdings (alphabetically)

Arena REIT

Australia

Real Estate

Arena REIT operates as a real estate investment trust. The Trust owns a portfolio in sectors such as childcare, healthcare, education and government tenanted facilities in Australia.

Charter Hall Group

Australia

Real Estate

Charter Hall Group invests in and develops real estate. The Company manages real estate investment funds and develops commercial, residential, and industrial properties.

Goodman Group

Australia

Real Estate

Goodman Group is an integrated industrial property group. The Group has operations in Australia, New Zealand, UK, Asia and Europe. Goodman's activities include property investment, funds management, property development and property services. The Group's property portfolio includes business parks, industrial estates, office parks and warehouse/distribution centers.

GPT Group

Australia

Real Estate

GPT Group is an active owner and manager of a diversified portfolio of Australian retail, office and industrial property assets. The Group's property portfolio include the MLC Centre, Australia Square, Rouse Hill Town Centre and Melbourne Central.

Shopping Centres Australasia Property Group

Australia

Real Estate

Shopping Centres Australasia Property Group is a real estate investment trust owning Woolworths Group anchored shopping centres and free standing retail assets.

As expected, the key focus of the FY22 reporting season was the impact of rising interest rates on earnings and valuations. REITs caught out by the rate rise were the ones with high gearing levels and low hedging profiles. For these REITs, the higher cost of debt has seen a drag to earnings revisions of around 2.5% for FY23/FY24. With the majority of REITs increasing hedging and extending hedging maturities, the vast majority of interest rate headwinds facing the sector are now known.

So where to from here? We believe REITs will be rewarded for 1) strong balance sheets through recycling of capital, and 2) access to capital through platforms.

Having a strong balance sheet is one of our key investment criteria. With the cost of debt increasing from an average of 2.5% at the beginning of the year to close to 5% now, the ability to recycle capital is key to achieving sustainable earnings growth.

We prefer REITs that have a capital light business model such as LIC. LIC is a leading Victorian manufactured housing estates (MHE) operator with approximately 2,800 operating units and a development pipeline of 2,300 over the next 3 years. It is one of the few REITs that rarely needs to raise equity due to its business model. Once a project is completed, capital is recycled into future development pipelines thereby reducing cyclical risks, such as rising debt or equity costs.

Other groups such as Dexus (DXS), Stockland (SGP), and Mirvac (MGR) have been selling non-core/lower quality assets to reposition the portfolio and recycle capital into developments. Both DXS and MGR have plans to divest $1bn and $1.3bn of assets respectively to deploy into their development pipeline. While SGP is looking to reduce its retail exposure to fund their industrial developments. We believe this strategy is riskier as it relies on the demand of the asset at that point in time.

Another way to obtain capital to fund acquisitions and developments is to have access to third party capital. Fund managers such as Charter Hall (CHC), Centuria Group (CNI), and Goodman Group (GMG) have established funds management businesses with demonstrated success in accessing third party capital through diverse sources including unlisted wholesale, unlisted retail, unlisted institutional, and listed REITs. These long term capital partners are able to look through short-term volatility and invest against longer term targets. This provides these groups with greater opportunities to gain market share in the current environment with counterparty risk and the ability to unlock more complex transactions. Currently, we view CHC as best positioned with $7.9 billion of investment capacity on the platform and approximately $600 million of cash on balance sheet, providing capacity for FUM growth even if there is a short-term slowdown in equity flows.

Later to the party include DXS (growing their funds management with the acquisition of Collimate and APN), while MGR and SGP are actively seeking capital partners for their development pipeline.

In a rising interest rate environment, the ability to secure capital and share funding costs is key. We continue to support fund managers such as CHC and CNI with strong capital partners and LIC with a strong product driven by secular trends and good capital structures.