Which REITs will shine even when growth slows?

The A-REIT sector fell -10.4% in June as central banks continue its tightening policy. The RBA’s 50 basis point rate hike and the continued strength in U.S. CPI (8.6%) weighed on sector sentiment.  As a comparison the Fund returned -9.8%, outperforming the index by 0.6%. The Fund benefited from an overweight position in Lifestyle Communities Ltd (LIC), SCA Property Group (SCP) and Arena REIT (ARF), whilst our weighting in Charter Hall Group (CHC) detracted from performance.

For the year to date, the sector fell -23.0% compared to the Fund that fell -27.1%.  The underperformance of 4.1% was mainly attributed to our overweight position in Centuria Capital (CNI -46.8%) and Charter Hall Group (CHC -46.4%).  Based on our valuation, both CNI and CHC are undervalued trading at FY23 PE multiples of 11x compared to their 5 year averages of 16x and 18x respectively.  As bond yield stabilises, we believe market sentiment will improve for these fund managers. Our overweight positions in SCA Property Group (SCP -4.7%) and Irongate Group (IAP +10.4%) benefited the Fund over this period.

Top Holdings (alphabetically)

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.

Mirvac Group Property Trust

Australia

Real Estate

Mirvac Group is an integrated, diversified Australian property group comprising an investment portfolio and a development business. The Company's investment portfolio, Mirvac Property Trust, invests in and manages office, retail and industrial assets and the development business has exposure to both residential and commercial projects.

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.

The sharp rise in bond yields from 1.5% at the beginning of the year to 3.6% in June continued to create headwinds for long duration assets such as REITs With the sharp rise in interest rates, the market has reacted swiftly, pricing in 100 basis point cap rate expansion and as a result, REITs have underperformed the broader equities market by 14% year to date.

So where to from here? We believe REITs have been oversold and are looking cheap on an NTA/NAV and PE basis relative to the past 10 years.  The sector is trading on an average 20% discount to NAV, 18% discount to NTA (ex GMG & CHC), and a sharp multiple de-rating with FY23 P/E declining from 18x at the beginning of the year to 15x currently.

Arguably, the first order impact of higher rates has now played out.  The second would be a slowdown in economic activities (if policies are effective in controlling inflation).  This is the environment where REITs, through their ability to pass through inflation, should shine even when growth slows.  The main reason behind this includes:

1. Leases are typically linked to CPI, especially for retail REITs where lease structures are typically CPI +2%
2. Real estate has a fixed capital model unlike companies that need working capital which would erode into profits with higher inflation
3. Real estate is a higher margin business (around 50%) so cost base inflation is less of an issue versus lower margin businesses.

In addition, we favour sub-sectors that have the pricing power to pass on inflation.  Currently, our preferred sectors are industrial REITs and the alternative sector such as childcare and healthcare.  Industrial REITs with sound fundamentals supported by low vacancy rates (<2% for Sydney and Melbourne) and continued demand for their product from e-commerce will be better placed to capture rental increases. In comparison, we are cautious about office REITs where vacancy and incentive levels are at record highs and are unlikely to see effective rental growth for some time.  The defensive nature of childcare and healthcare also provides a natural hedge from inflation as they are considered necessities and are less cyclical than your office, retail, and industrials.

Our Fund is well placed to hedge against inflation with 22% of the portfolio exposed to industrial REITs and 25% in the alternative sector.