Inflation peaked but volatility remains

The Fund delivered another month of outperformance in June, closing with a +0.52% return compared to the S&P/ASX 300 A-REIT Index of -0.09%.  For the 2023 financial year, the Fund delivered strong performance of +9.54% compared to the Index return of +7.49%, generating outperformance of +2.05%.

Pleasingly, many of the top contributors to the Fund’s outperformance over the 2023 financial year were our non-index holdings including Peet Ltd (PPC +40.18%), Lifestyle Communities (LIC +16.21%), Qualitas Ltd (QAL +19.96%) and NextDC Ltd (NXT +19.34%). The key characteristics of these holdings are that they are underpinned by secular trends and less sensitive to the rise in inflation and interest rates.

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.

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.

Scentre Group

Australia

Real Estate

Scentre Group Limited owns and operates pre-eminent living centre. The Company specializes in the management, development, construction, leasing, and retail solutions. Scentre Group serves customers in Australia.

Stockland

Australia

Real Estate

Stockland is a diversified Australian property group. The Group develops and manages Retail centers, Residential Communities and Retirement Living assets with a focus on regional centers and outer metropolitan. Stockland also owns a portfolio of Office and Industrial assets.

The Fund delivered another month of outperformance in June, closing with a +0.52% return compared to the S&P/ASX 300 A-REIT Index of -0.09%.  For the 2023 financial year, the Fund delivered a strong performance of +9.54% compared to the Index return of +7.49%, generating an outperformance of +2.05%.

Pleasingly, many of the top contributors to the Fund’s outperformance over the 2023 financial year were our non-index holdings including Peet Ltd (PPC +40.18%), Lifestyle Communities (LIC +16.21%), Qualitas Ltd (QAL +19.96%) and NextDC Ltd (NXT +19.34%). The key characteristics of these holdings are that they are underpinned by secular trends and less sensitive to the rise in inflation and interest rates.

The last financial year was all about the rising cost of capital in response to stubbornly high inflation rates. This led to 3 themes that dominated the market:

1. Balance sheets are under scrutiny as the cost of refinancing rises.
2. Wide gaps in valuations between direct property and listed markets.
3. Effects of the pandemic still lingering in places such as the office market with the WFH thematic, and developers still grappling with labour shortages and high construction costs due to inflation.

Looking ahead, inflation seems to have peaked but it remains significantly higher than the RBA’s target range (2-3%).  Over the next six months, we continue to see the sector being driven by a macro environment of high inflation, high interest rates, and low growth.  With this in mind, here are the key questions we want to address:

1. Can the AREIT sector grow earnings into FY24 given the impact of higher rates?

The inflation hedge characteristics of REITs with rental growth often linked to CPI have generated an estimate of 5% in headline earnings growth.  However, with the significant rise in the cost of debt (from ~2.5% to now ~6%), earnings growth at an operating level has halved.  The ability to deploy capital effectively is key to achieving positive earnings growth.  REITs that are best placed to achieve this are those with strong balance sheets to fund future acquisitions and developments, and those operating in sub-sectors that have favourable fundamentals and operational matrices such as logistics.

2. Where will valuations end up and can the gap be closed?

Based on REITs that have reported June 2023 revaluations so far, the average expansion in cap rates is 25bps since December 2022 and 33bps since June 2022, equating to a drop in asset values of 6%. Logistics assets proved most resilient with strong income growth offsetting cap rate expansions, whilst office assets experienced the greatest value declines largely due to limited income growth. Given that cost of capital has increased significantly and the economic outlook has weakened, we believe there is further downside risk to valuations, particularly in sub-sectors such as office where there is little earnings growth to offset the rise in the cost of debt.  June saw the re-emergence of transaction activity with REITs being net sellers to strengthen their balance sheets. With more transactional evidence expected to come through over the next few months, we will gain greater clarity on where valuations will end up.  As it stands, the listed market has arguably already factored in greater devaluations as the majority of REITs are trading at an average of 20-30% discount to their book value.  We remain cautious and adopt a conservative forward view on cap rates, factoring in +30bps expansion for retail, +50bps expansion for industrial and +70bps expansion for office.

The pause in the rate hike in July indicates to the market that inflation has peaked. Looking forward we could see stabilisation in rates which should be supportive for the REIT sector.