What does a peak in interest rates mean for the residential sector?

The A-REIT sector delivered a solid start to the new financial year, up +3.8% in July as economic data released during the month showed the effectiveness of the interest rate tightening cycle with 1) a softer inflation print (6.0% vs. consensus 6.1%); and 2) weaker June retail sales.

In comparison, the Fund returned +3.38% which was a solid result notwithstanding our bias toward non-index stocks.  Key contributors to returns over the month include Lifestyle Communities (LIC +10.86%), HealthCo Wellness REIT (HCW +8.37%), and RAM Essential Services (REP +7.97%). The top detractors of performance were Qualitas (QAL -5.20%) and Arena REIT (ARF +1.06%).

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.

HealthCo REIT

Australia

Real Estate

HealthCo REIT, doing business as HealthCo Healthcare and Wellness REIT, operates as a real estate investment trust. The Company invests in hospitals, aged, child, government, life sciences, research, primary care, and wellness property assets. HealthCo Healthcare and Wellness REIT serves clients in Australia.

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 RBA left cash rates unchanged at 4.1% for the second consecutive month as inflation seems to have peaked at 6.0%.  With this in mind, we unpack below what this means for the residential sector, which has been most impacted by the rate changes.

Looking at the demand/supply dynamics, COVID saw government stimulus and ultra-low interest rates drive extreme residential demand, but production was impacted by lockdowns and supply chain shortages in both materials and labour.  Three years on from COVID and we are still in an environment where housing shortages are driving low rental vacancies to below 1% in Sydney and Melbourne. Added to this complexity are the ongoing affordability challenges. As mortgage rates have increased from around 2% to 6%, we have started to see mortgage stress in certain segments of the market, with mortgage repayments approaching a record >40% of income compared to an average of 20-30%. On the supply side, challenges remain in construction cycles – whilst wet weather impacts and freight costs have eased, input costs and the lack of skilled labour are likely to persist with competition from various infrastructure projects such as the Olympics in Brisbane and the road and rail networks in Sydney.

So, what does this mean for a recovery in the residential sector? We believe the recovery is being pushed out even though demand is greater than supply mainly due to our view that inflation will be more persistent. This suggests that rates will be “higher for longer”, which will restrict buyer’s ability to obtain finance.  For residential developers, we believe sales volume will come off from the record levels of 2021, but prices and margins will be maintained.  Longer term drivers of lower rates combined with strong population growth and the return of immigration (estimated to be over 700,000 immigrants over the next two years) will provide further support for the sector.

As a result, our preference is for more affordable products such as those owned and developed by Stockland Group (SGP) and Peet Group (PPC), and land-leased products in retirement living such as Lifestyle Communities (LIC).