When offence is the best defence: Capitalising on the Global REIT Transition

With motivated vendors and the cost of capital more certain, a transition to a new normal for investing conditions is in full swing. For Global REIT investors, now is the time to strike.

Global REIT managers have had it tough these past few years. The pandemic and ensuing rise in interest rates put much of the sector into a corner. Most REITs had to quickly vary their playbooks from one that enjoyed cheap and abundant capital to focusing on balance sheet management and protecting cashflow, exactly as circumstances required.

The impacts are now visible. The sharp rise in rates led to lower valuations and weakened balance sheets. While many landlords remained well-capitalised, the facts did not matter. The label on the REIT tin was more important than its contents. From the beginning of 2023 to now, equities have outperformed REITs by a significant 31%. Indeed, many of the highest quality, well capitalised and managed global REITs continue to trade at significant discount to net tangible asset value.

As explained in Global REITs - . We don’t know when interest rates will drop, but we do know zero interest rates are a thing of the past. Capital now has a cost. The rules of the game have changed. Investment markets are moving to a likely fertile new normal. Inflation is not yet tamed but is either stable or slowing and rates have yet to fall.

History suggests such periods are a source of opportunity. In allocating capital for the Dexus Global REIT Fund, we have been taking advantage of these opportunities, although we understand for some this isn’t easy. The period demands a change in mentality but, as uncomfortable as it may feel, the potential rewards are a fitting incentive.

Here, we’re going to look at where we believe the opportunities lie and what criteria we’re using to evaluate them. We will also discuss select REITs occupying a core position within the Fund.

The great REIT myth

Let’s first expose what we call the great REIT myth. Those investors taking only a cursory look at commercial property gearing have thrown REITs into the same category as higher-leveraged unlisted property owners and private equity investors.

These sectors typically leverage their portfolios at 50% or more while most global REITs have maintained a headline gearing level well below it. They are not alike. Across our coverage universe, average gearing is c.35%. REITs are more conservatively managed and financed than other ownership structures to which we feel they are being (inappropriately) compared. The risk of buying attractively priced REITs is not as significant as many investors may believe.

So, where are the opportunities?

For some highly-levered private equity portfolios that ‘kicked the can down the road’ with short-term refinancing, the latest rate resurgence will likely prompt more aggressive liquidations. Many of these asset owners are being forced into a corner, pausing developments to reduce portfolio pressures and manage gearing covenant levels. Their difficulties are our opportunities.

The criteria of opportunity

Already, there are signs of activity. Select Global REITs are actively deploying capital, either from surplus cash, equity raised directly from investors, or existing scrip as currency in the case of mergers and acquisitions. 

Each allows them to take advantage of distressed sales. In some cases, including the examples below, these immediately add value. There are two criteria we look for in global REITs best able to capitalise on these opportunities:

1. Excellent balance sheet positions with the flexibility to deploy capital;

2. Investment opportunities where market dynamics allow for rental tension and growth;

On the first criteria, a key metric to assess leverage is the net debt/EBITDA ratio. This describes how many years it would take for debt to be eliminated if a REIT’s earnings were completely directed to debt repayment.

The chart below shows that, except for European REITs, current global REITs’ net debt/EBITDA ratios are broadly in line with 20-year average and, in some cases, below it. This should provide investors with added confidence in the sector’s balance sheet strength.

Historical Net Debt / EBITDA – Global Listed Real Estate

Source: UBS Research

In the US, management teams took advantage of low rates prior to the Federal Reserve rate increases that began in March 2022, as REIT sector issued record amounts of unsecured public debt at low rates . This, along with the Australian REITs’ post-GFC conservatism in balance sheet management, also explains their low ratios.

In Europe, the outlier effect is clear, and a little misleading. German residential landlords took on higher levels of leverage and, over the last decade, a high proportion of fixed rate debt was issued at low coupon rates. Both factors skew the ratio.

While this will lead to higher debt refinancing costs, many select European REITs have an extremely well-managed debt book. Financed by long duration bonds, these offer a reliable buffer while there is the opportunity for top-line revenue growth to offset future increase in interest costs. We are not discounting Europe as a hunting ground for potential opportunities (see below), quite the opposite in fact.

Select Global REITs

With surplus cash balances and the ability to raise debt if needed, we have identified several attractively priced Global REITs that have already taken advantage of attractive, value-adding opportunities. Here are some examples.

US logistics REIT, Rexford Industrial (NYSE:REXR) is a highly specialised REIT already playing offence. This specialised logistics landlord and developer services only the inner urban first and last mile markets in southern California. It recently acquired a US$1.3 billion portfolio from an unlisted vehicle managed by a private equity investor contending with some well-publicised investor redemption requests. 

Highlighting the nature of the opportunity, the transaction was in part financed through a US$840m equity placement from a single and existing long-only investor. This acquisition will provide REXR with immediate earnings growth and the opportunity for longer-term value creation as they use their expertise to unlock latent portfolio opportunities.

Also in the US, gaming and leisure REITs, Gaming and Leisure Properties (NASDAQ:GLPI) and Vici Properties (NYSE:VICI) are continuing to play offence. Their strong capital positions have allowed the purchase of diverse leisure and hospitality assets that will make an immediate contribution to earnings accretion, with strong prospects for loner-term value creation. 

Turning to the UK, logistics and diversified landlord LondonMetric Property (LSE:LMP) has over the last 12 months opportunistically (and sensibly) used its relatively high value scrip to consolidate the UK REIT sector.

It first acquired CT Property Trust, a relatively small-capitalisation UK REIT with a portfolio of logistics and industrial property, at a discount to net asset value. Even more impressively, it then secured a merger with LXI REIT, consolidating a £3 billion long-leased, diversified portfolio, including high-barrier entertainment and healthcare assets. The merged group will now enjoy higher levels of liquidity, a broader investor base and cheaper debt finance.

The highly experienced, credentialed management team aims to compound income-based returns over the longer term and are track for a ninth consecutive year of dividend growth—no mean feat given the period includes a pandemic—we’re excited to have this company in the Dexus Global REIT Fund portfolio.

These are just select examples of the kind of opportunities we’re uncovering. Over the past few years, REIT investors have had slim pickings. With motivated vendors and the cost of capital stabilising, now is the time to be strike.

^{Sources:
1 MSCI World Index (AUD less the GPR 250 REIT Index (AUD) total return} 

^{2 NEREIT Research}

^{This material (“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 the Dexus Global REIT Fund (ARSN 642 411 292). DXAM is a wholly owned subsidiary of Dexus (ASX: DXS).} 

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