The new normal

Following a strong performance of +7% in May,  the AREIT market gave some gains back in June with the S&P/ASX 300 AREIT Accumulation Index finished the month down 1.2%.  The Fund returned +0.2%, outperforming the benchmark by +1.4%.¹

Top Holdings (alphabetically)

APN Convenience Retail REIT Australia Retail REITs

Charter Hall Retail REIT Australia Retail REITs

Charter Hall Social Infrastructure REIT Australia Specialized REITs

Goodman Group Australia Industrial REITs

Ingenia Communities Group Australia Residential REITs

Following a strong performance of +7% in May,  the AREIT market gave some gains back in June with the S&P/ASX 300 AREIT Accumulation Index finished the month down 1.2%.  The Fund returned +0.2%, outperforming the benchmark by +1.4%.

June saw the majority of AREITs announced their dividends which were down on previous years due to the uncertainty of COVID-19 on rent collection and asset valuation prompting management teams to preserve balance sheets.  The majority of the reduction in distribution came from the retail sector, with Scentre Group (SCG), Vicinity Group (VCX) and Carindale Property (CDP) opting not to pay 2H distributions while the diversified sector such as Mirvac (MGR), GPT Group (GPT) and Stockland (SGP) declared distributions on average 20% below previous years.  Distributions across office, industrials and long WALE (weighted average lease expiry)vehicles prooved to be resilient with distributions down less than 5%.

Preliminary June valuations saw retail book values come under pressure with an average decline of 10% whilst office and industrial valuations have been largely unchanged.

Putting the first 6 months of 2020 behind us, how are we positioned for the next six months?

We remain cautious as there is still a lot of uncertainty around the recovery of the economy once the impacts of government stimulus, rent relief and interest deferrals come to an end.

We continue to position our portfolio towards REITs that have the following attributes;

• Positive free cash flow
• Strong balance sheet (not just Loan to Value Ratio but Interest Cost Ratio)
• Favourable thematic drivers or long WALE

It is this stringent investment approach that has resulted in the portfolio holding four REITs that were able to re-affirm their earnings and avoid exposure to REITs that have withdrawn distributions.

With our underweight position to discretionary retail, we were able to allocate to better growth sectors such as seniors living, manufactured housing, real estate managers, childcare and logistics.  All of these provide more sustainable earnings driven by secular trends and are often less cyclical than the traditional sectors such as retail, office and industrials.

Overall, the AREIT sector is expected to generate an average dividend yield of 4.8% with 1% to 2% earnings growth.  This represents a yield spread of 390 basis points to Australian 10 year bonds and 470 basis points to the RBA cash rate.

Market outlook

For a traditionally low beta sector, COVID-19 has brought on significant volatility with the sector being down 35% in March 2020 followed by a 20% rally in the June quarter. The fall was mainly driven by large retail landlords, which are now trading at large discounts to NTAs (40%-50%).

This volatility can in part be attributed to the deterioration of earnings certainty as many REITs had to withdraw earnings and distribution guidance to accommodate expected cuts to contracted rents, which we believe is already reflected in their share prices.

In terms of balance sheet, we believe that AREITs are in much better shape compared to the GFC when the average gearing was 45% to book value compared to today at 26%.  Liquidity is far better and covenant pressure is unlikely to tip REITs into forced capital raisings (like in the GFC).

In the long term, there are cyclical headwinds, which include higher unemployment rates and lower GDP growth, which all industries would have to navigate through over the medium term. The one silver lining is that REITs typically have long and legally contracted leases (average 4-5 years) which provides protection to earnings.

Importantly, Covid has accelerated some of the inevitable structural changes such as the adoption of online retailing and more flexible working options. We remain underweight discretionary retailing as we see this as having the largest risk to earnings in the short term with the potential “second wave” of COVID-19 induced shutdowns and in the long-term structural headwinds from growing penetration of on-line retailing. In terms of the impact of “working from home” it is too early to predict.  We have, however, positioned towards metro offices which typically have a higher exposure to government tenants and on average have longer lease terms.

With every shock and structural shift, there are winners and losers.  The logistics assets are the key beneficiaries of the growth in on-line retailing. Amazon’s recent announcement regarding their commitment to another distribution center in Sydney, making it their fifth DC in Australia, further validates this.

As uncertainty of COVID-19 passes the focus will be on the defensive attributes of well-managed property securities. REITs with a strong balance sheets and sustainable earnings growth will be supported especially in this low interest rate environment.