FY22 Reporting Season Wrap
Article10 mins31 October 2022
FY22 was a tale of two halves. After a strong first half driven by lower interest rates and increasing asset values, the move to a tightening monetary policy drove underperformance in REITs, as higher interest rates increased financing costs and impacted the earnings outlook. Despite the continuing uncertainties around financing costs, the majority of REITs remain positive and have continued to provide guidance into FY23, with the following key takeaways from the FY22 reporting season as follows:
1) Debt Costs Up
Increasing interest rates dominated reporting season and were the predominant driver of wider earnings/distribution guidance ranges for FY23. The evolution of these rates can be seen in the chart below.
Hedging was also a primary focus. The sector increased its hedging to ~75% for FY23 with further increases post-balance date as hedging costs came down following their June peaks. This highlights the active approach AREITs take to managing their debt books. Balance sheets remain well capitalized with gearing at ~26% across the sector providing sufficient capacity in the event of asset devaluations.
Floating rate debt cost
Source: Bloomberg, Goldman Sachs Global investment Research
2) Earnings revised down but still growing
Re-leasing spreads varied by sector with industrial and self-storage both recording double-digit growth followed by single-digit spreads in retail and flat spreads in office. Rental growth into FY23 is largely expected to remain positive, but it is expected to moderate from last year. As such, the earnings outlook for FY23 remains cautiously optimistic with rental growth somewhat offsetting increased debt costs resulting in a ~1.3% decrease in earnings vs. FY22.
Source: Company filings*, DXAM. *Mid-point has been used for guidance
3) Asset valuations stable…for now
All AREITs recorded some cap rate compression over FY22 with industrial and neighborhood retail seeing the greatest declines. The rate of compression slowed in the second half as rising interest rates started to have an impact and transaction volumes slowed. Further increases to financing costs are expected to result in cap rate expansion into FY23 which is reflected in the listed AREITs that are currently trading at a ~25% discount to their stated book values. This is despite no large upward cap rate movements yet being observed in the direct market, with ongoing rental growth holding asset values firm for the time being.
Source: Macquarie Group
4) Focus on development returns
Development pipelines remain a core focus for future AREIT earnings growth, with capital recycling being considered to fund these projects. Construction costs remain elevated, decreasing expected returns for proposed developments where costs are yet to be fixed. The sectors with the most active development pipelines are industrial, office and alternatives. Industrial pre-commitments for new developments remain high and rents are being achieved in excess of initial project feasibility analysis, as demand continues to outstrip supply and underpin strong returns. The ongoing flight to quality office theme is gaining momentum with many tenants upgrading their space to obtain additional amenities and improved ESG credentials to encourage staff back to the office. Balance sheets remain well positioned to fund these projects with sector gearing at ~26% which is below long-term averages.
Source: Company filings*, DXAM
5) Residential decelerating quickly
Following the residential housing boom over the last two years, sales growth moderated as stimulus rolled off and rates rose in the second half of FY22. While settlements for FY23 are well placed, slowing enquiries will impact earnings into FY24 and beyond. Market sentiment remains weak with auction clearance rates slowing materially from over 80% to sub 60% in recent months. This decrease in sentiment is reflected in the assumptions provided by the residential developers, with an increase in the expected default rate. However, limited new housing supply, a tight rental market and increasing immigration provides support to this sector.
Source: Domain, Macquarie Group
Despite a myriad of uncertainties, over 90% of AREITs provided some form of guidance for FY23. For income investors, AREITs are now back to pre-pandemic cash collection levels, with solid rental growth linked to inflation which should help to offset rising interest costs. Listed AREITs are currently trading at an average discount of 25% to NTA, despite no material asset devaluations being observed at the June 2022 financial year end. With the Dexus AREIT Fund offering a 6.1% distribution yield, investors are receiving a competitive income return while markets recalibrate towards more normalized levels of inflation.
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