2022 in review

The Fund generated a -3.6% return for December and +12.0% for the quarter. In comparison, the A-REIT sector retraced some of the previous two month’s performance to close down -4.0% for the month and returned +11.6% for the quarter.

The main positive contributors to the Fund’s performance in December were investments in Qualitas Ltd (QAL), Healthco Healthcare and Wellness REIT (HCW), and Lifestyle Communities (LIC).

For the calendar year, the A-REIT sector was down -20.1%, and significantly underperformed the broader equities market which was down -1.8%. The Fund returned -23.2% with the main detractors to performance being our overweight holdings in Fund Managers such as Centuria Group (CNI) and Charter Hall Group (CHC). We expect Fund Managers to report strong earnings in the upcoming 1H23 reporting season, restoring confidence in their business model.

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.

Qualitas Ltd

Australia

Real Estate

Qualitas Limited operates as a real estate investment management firm. The Company specializes in real estate investment, private equity, investment management, superannuation, risk management, and refinance solutions. Qualitas serves customers worldwide.

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.

2022 was characterized by sharp movements in bond yields and cash rates rising steeply in response to higher inflation. The impact on A-REITs was felt primarily through higher debt costs, impacting on cost of capital and required returns on investments. A-REITs caught out by higher floating rate debt costs were punished by investors over 2022 and those with sound hedging levels and balance sheet positions were rewarded.

Looking at each of the sub-sectors, retail REITs were the best performer as foot traffic returned to malls after a COVID-impacted 2021. Surprisingly throughout the year, consumers proved remarkably resilient in the face of higher inflation and rising interest rates. We attribute this to a lagging effect between changes in the cash rates and adjustments to mortgage payments, as around 35% of households have fixed-rate mortgages and around 60% of those will expire by the end of next year. As a result, we anticipate retail sales, particularly discretionary retail, will become weaker at a time when real disposable incomes are falling, and the savings rates are nearly back at pre-pandemic levels.

The office market is still challenged despite the re-opening post COVID lockdowns. Physical office occupancy is still low at 58% as the work-from-home (WFH) trend is becoming entrenched. More people are choosing at-home or hybrid working arrangements, reducing their commute to work in the office from 4.2 days to 3.6 days. The estimated impact will be a reduction in demand for space with mitigating factors including a flight to quality. When we combine the structural shift of WFH with the increase in supply over the next 2 years for the major capital cities, the outlook for office is a sustained weak operating environment with expected high vacancies of 12%-15% and high incentive levels of 30%-40%. While this is largely reflected in implied cap rates, it is not yet captured in book values (e.g. Dexus Group (DXS) was trading on an implied cap rate of 6.3% as of 31 December 2022 compared to its book cap rate as of 1H23 of 4.9%).

Industrial assets, particularly infill logistics, continue to benefit from strong rent growth as vacancy rates are at record lows, particularly for South Sydney at 1.5%. CBRE indicated rental growth for prime assets for the year was at 25%. Early evidence from 1H23 valuation updates highlighted that strong rent growth had largely offset the impact of cap rate expansions.

Fund Managers underperformed in CY22 as interest rates lifted sharply. The rise in rates affects the Fund Managers in two folds:

1. It impacts the valuation of their existing assets, putting pressure on FUM; and
2. It increases the cost of capital, making acquisitions and developments less attractive, thereby impacting on future growth.

We believe Fund Managers have been oversold and are trading at attractive valuations.

As we head into 2023, the crucial question is “are we moving into a regime of structurally higher rates, or will rates come back down?” We are firmly of the latter view, which is supportive of the listed real estate market. On some metrics, the A-REIT sector has rarely looked this cheap. As of 31 December 2022, the sector was trading at an 18% discount to NAV, a 20% discount to NTA (excluding CHC and GMG), and an average PE ratio of 14x. We believe stabalising interest rates will support the sub-sectors that have been oversold, including Fund Managers such as Charter Hall Group (CHC), Centuria Group (CNI), and HMC Capital (HMC).

The Fund continues to focus on free cashflow, sustainable earnings, and a strong balance sheet. We favour the logistics sector and Fund Managers based on quality and growth, and the alternative sub-sectors for their defensive earnings.