Commentary

The AREIT sector has had a strong come back since falling 35% in March 2020.  For the six month period to the end of September, the sector rallied 29%, outperforming the broader equities market by 13%.

The outperformance of the AREIT sector was largely due to the following drivers:

1. Things were not as bad as originally expected, with rental collection for office and industrial assets remaining high – on average more than 95%. Rental collection for retail assets was below 50% but headline collection rates showed an improvement as economies started to reopen.
2. The AREIT sector showed value with the spread to 10-year bonds of 330 basis points comparing favourably to the long term average of 200 basis points.

Since the pandemic, the dispersion between quality/income security versus value has widened even further with the top performing stock, Goodman Group (GMG), up 20% compared to Scentre Group (SCG) and Vicinity Group (VCX) both down 36%. The worst performing stock, Unibail- Rodamco (URW), was down 72% since the beginning of March 2020.

Will this disparity continue? We believe it will for the following reasons:

• Earnings uncertainty for large mall-exposed REITs remains when accounting for COVID-19 rental assistance (waivers, deferrals). We’ve seen some REITs choosing to accrue deferrals, which leads to free cashflow being on average 30% below operating earnings. This gap is estimated to continue into FY21.
• Cyclical headwinds as government stimulus starts to roll off and the economy is expected to undergo higher unemployment and lower GDP growth. During a recession, we expect an increase in store consolidations, putting greater pressure on effective rents and vacancies.
• Online retail growth is still exceeding bricks-and-mortar growth, a trend we expect to continue with online retail continuing to gain market share (from 11% to 19% over the next two years).
• Stretched balance sheets, particularly given greater risk of asset value declines. During the month, both SCG and URW addressed this issue with SCG issuing A$4.1 billion in subordinated hybrid notes in the U.S. market whilst URW announced its “RESET” plan involving a €3.5 billion equity raise (i.e. rights issue), dividend and capital expenditure reductions and a proposed €4 billion of asset sales. The key question for us is: will these measures be sufficient to weather the storm? Only time will tell but based on global peers we anticipate there to be further write downs in asset values from the last reported with falls of just over 10%.

On the flip side, GMG is benefiting from the structural shift of online retailing as logistic assets form part of the supply chain for food and delivery of parcels. This is evident from Amazon’s decision to lease a Sydney warehouse from GMG, alongside large pre-commitments by Coles and Woolworths, lifting the amount of industrial space leased in Australia to a five-year high in 2Q 2020. Between April and June, ~871,000sqm of industrial floor space was leased nationally, according to figures compiled by JLL.

When you couple this structural tailwind with high quality management and a strong balance sheet (gearing of 10%) to take advantage of growth opportunities through developments or acquisitions, the earnings outlook is a lot more secure. GMG has development work in progress to exceed $5 billion by the end of FY20.  We expect development margins to remain solid with a healthy spread between prime industrial cap rates of 4%-5% and development yields of 6.5%.

Our investment thesis remains focused on three key factors:
1. Positive free cash flow
2. Strong balance sheet
3. Favourable thematic drivers and long WALEs (weighted average lease expiry).

The Fund is not exposed to discretionary retailing with a zero weighting in SCG, VCX and URW.  Our main exposure is in fund managers and developers, such as Charter Hall Group (CHC), Centuria Capital (CNI) and Goodman Group (GMG), and alternative assets. This includes childcare, seniors living, data centres, and affordable housing such as Manufactured Home Estates. We believe these sectors provide both sustainable earnings growth driven by secular trends and diversification from the traditional core sectors of retail, office and industrial.