AREITs back off the floor (again)

The past few years have been challenging, and investing in AREITs has been no exception. After a decade of reliable returns prior to 2020, a global pandemic made panic the norm. From an investment perspective, there were few places to hide.

In the 2020 financial year, lockdowns and a high exposure to retail ensured AREITs underperformed equities. The leasing code of conduct that mandated tenant financial support slugged the sector. Retail (notably discretionary) was hit hard and the (still) unknown impact of work from home (WFH) on the office sector added to the uncertainty. 

The divergence in performance was stark, with industrial and alternative asset sectors far outperforming retail and office. However, this outperformance didn’t make up for the office and retail shortfall, which accounts for around 60% of the AREIT index and explains the sectors' weak performance relative to other asset classes. 

In the early stages of the crisis, we readjusted the Dexus AREIT Fund portfolio to minimise our exposure to discretionary retail and CBD office, while increasing allocations to the industrial and alternative asset classes that performed relatively well throughout the pandemic, such as childcare and service stations. 

Then came the recovery. After the pandemic-induced lows of March 2020, AREITs rose 33.2% and equities 27.8% in the 2021 financial year. AREITs in particular were driven by the investment themes of funds management, logistics and storage along with the COVID recovery trade. 

The 2022 financial year was a tale of two halves. In the six months to 31 December 2021, AREITs delivered a stunning return of 15.3% compared to 4.0% from equities. In the following six months to June 2022, there was a staggering reversal. AREITs fell 23.0%, while equities dropped 10.4%. After a year that started with so much promise, AREITS returned -11.2% over FY22, 4.4% lower than equities, which returned -6.8%.

So, what’s behind the recent performance and what can we expect of the future?

The optimism engendered by cashed-up consumers exiting lockdowns and spurred by stimulus spending and global recovery, has been followed by pessimism as supply chain constraints and the invasion of Ukraine encouraged inflation in tight labour markets. As rates rise, the threat of recession looms ever larger.

This has affected the AREIT sector in three ways.

Source: S&P; Period 2/1/2019 to 25/07/2022.

First, companies carrying higher debt (gearing) with lower levels of debt hedging have been punished. Debt is now on the nose. Despite their relatively predictable earnings, investors have little regard for the AREIT sector's low average gearing of 25%, which is well below the long-term average of 30%. 

Such fears are unwarranted.  In the post-global financial crisis period, AREIT management teams reduced their use of debt, expanded funding sources and extended debt tenure. This helped reduce risk and offered a level of earnings shelter through periods of interest rate volatility. These are admirable characteristics in this environment.

Second, after an incredibly strong few years, funds management and logistics AREITs like Goodman Group (ASX:GMG) and Charter Hall Group (ASX:CHC) have been punished. As investors reassess their ability to maintain rapid growth, there has been a significant reduction in the earnings multiples applied to future growth.

GMG was down 33% over the second half of FY22 while CHC fell a staggering 46%. At the beginning of 2022, these two stocks accounted for over 34% of the AREIT index. Their dramatic share price declines have therefore hit the AREIT index hard.
Both stocks attracted investors with little regard for real estate fundamentals. Once the change in market psychology took place, they quickly departed.

While these companies became victims of their own success, they remain large, high-quality, diversified businesses carrying relatively low levels of debt. That said, the growth they offer comes at a price, especially when compared to other REIT markets globally.

Finally, AREIT analysts have been lowering earnings expectations and forecasting the value impacts of higher rates in the year ahead. This has added to the pressure on AREIT share prices.

A global pandemic followed by the largest global inflation outbreak in 30 years, has created a treacherous environment. After a difficult financial year, AREIT investors are under the pump but can take comfort from a few factors that have been forgotten lately.

In eight of the last 12 years, AREITs have outperformed equities. During the current conflagrations, AREIT landlords will continue collecting rents from a diversified pool of quality tenants. This should provide a level of earnings certainty in an uncertain environment which will gain the attention of investors at some point.

As we have written previously, AREIT investors tend to benefit when interest rates are rising, though often underperform leading into the initial threat of higher rates. [See It’s (not) the end of the world as we know it (and we feel fine) and conventional wisdom is wrong. Rate rises are good for property trusts].

A significant proportion of rental contracts are inflation linked. Rising interest rates do increase the cost of debt servicing, but for AREITS the increases in rents received will assist in diminishing this impact.

For income investors worried about the impact of rising rates, AREITs offer a safe harbour, reasonable returns and a reliable income stream. That’s something to think about in this environment.



^{This article (“Material”) has been prepared by Dexus Asset Management Limited (ACN 080 674 479, AFSL No. 237500) (“DXAM”), the responsible entity and issuer of the financial products of insert name of APN AREIT Fund mentioned in this Material. DXAM is a wholly owned subsidiary of Dexus (ASX: DXS).} 

^{Information in this Material is current as at date of publish (unless otherwise indicated), is for general information purposes only, does not constitute financial product advice and does not purport to contain all information necessary for making an investment decision. It is provided on the basis that the recipient will be responsible for assessing their own financial situation, investment objectives and particular needs. Before deciding to acquire or to continue to hold a product in any fund mentioned in this Material, investors should read the relevant product disclosure statement (“PDS”) and target market determination (“TMD”) in full, and seek independent legal, tax and financial advice. The PDS and TMD are available from DXAM, Level 5, 80 Collins Street (South Tower), Melbourne VIC 3000, by visiting www.apnres.com.au or by phoning 1800 996 456. The PDS contains important information about risks, costs and fees (including fees payable to DXAM for managing the fund). Any investment is subject to investment risk, including possible delays in repayment and loss of income and principal invested, and there is no guarantee on the performance of the fund or the return of any capital. This Material does not constitute an offer, invitation, solicitation or recommendation to subscribe for, purchase or sell any financial product, and does not form the basis of any contract or commitment. This Material must not be reproduced or used by any person without DXAM’s prior written consent. This Material is not intended for distribution or use in any jurisdiction where it would be contrary to applicable laws, regulations or directives.}

^{Any forward looking statements, opinions and estimates (including statements of intent) in this Material are based on estimates and assumptions related to future business, economic, market, political, social and other conditions that are inherently subject to significant uncertainties, risks and contingencies, and the assumptions may change at any time without notice. Actual results may differ materially from those predicted or implied by any forward looking statements for a range of reasons. Past performance is not an indication of future performance. The forward looking statements only speak as at the date of this Material, and except as required by law, DXAM disclaims any duty to update them to reflect new developments.} 

^{Except as required by law, no representation, assurance, guarantee or warranty, express or implied, is made as to the fairness, authenticity, validity, suitability, reliability, accuracy, completeness or correctness of any information, statement, estimate or opinion, or as to the reasonableness of any assumption, in this Material. By reading or viewing this Material and to the fullest extent permitted by law, the recipient releases Dexus, DXAM, their affiliates, and all of their directors, officers, employees, representatives and advisers from any and all direct, indirect and consequential losses, damages, costs, expenses and liabilities of any kind (“Losses”)  arising in connection with any recipient or person acting on or relying on anything contained in or omitted from this Material or any other written or oral information, statement, estimate or opinion, whether or not the Losses arise in connection with any negligence or default of Dexus, DXAM or their affiliates, or otherwise.} 

^{Dexus, DXAM and/or their affiliates may have an interest in the financial products, and may earn fees as a result of transactions, mentioned in this Material.}