Views diverge over rate hikes impact on REITs
By Tim Boreham
Property analysts are taking diverging views on the health of the $135 billion listed real estate investment trust sector, given the unfamiliar climate of rising interest rates and inflation.
Wisdom says REITs suffer because of the higher cost of servicing debt and diminishing economic activity that erodes rents and the quality of tenancies.
But property is also being viewed as a “real” asset with defensive qualities, especially when leases allow for rents to be raised in line with inflation.
Citi property analyst Suraj Nebhani contends that valuations may already have overcorrected, with past experience showing REITs actually may benefit in a higher rates cycle.
The ASX REIT sector has tumbled 20 per cent in the year to date, compared with a circa 8 per cent decline for ASX200 stocks.
Nebhani says REITs generated negative absolute returns in only four of the eight rising rates cycles. They were more likely to underperform up to 60 days before the first rates hike, but this tended to reverse in the 60 days after the increase.
Strong tenant occupancy trends translate into the power to push up rents as tenant sales grow.
Ashton Reid, portfolio manager at Martin Currie Real Income Fund
The Reserve Bank lifted the official cash rate by 25 basis points to 0.35 percentage points on May 2. It was the first increase since 2010.
“While we acknowledge the headwinds from the [expected rate rises] in the absence of any weakness in direct markets, historical evidence suggests that the sector might have underperformed more than warranted,” Nebhani says in a report.
JP Morgan analysts are taking a sterner view, reducing sector valuations by an average 6 per cent given the rising longer-term bond rates on which REIT funding is usually priced.
Inflation-adjusted “real” yields are most important to the sector, as opposed to the quoted nominal rates. JP Morgan notes that real Australian 10-year government bond yields have risen 140 basis points so far this year, to 0.9 per cent, their highest level since 2018.
The firm notes that inflation helps REITs such as Scentre Group, Charter Hall Retail, Carindale Property Trust and Bunnings landlord BWP Trust, which have CPI-linked rent reviews written into their lease agreements.
The owner of Westfield malls, Scentre Group, has annual rent escalators of inflation plus 2 to 3 per cent on many of its specialty leases.
About half of the Charter Hall Long WALE (weighted average lease expiry) REITs’ diversified tenancies are inflation linked.
“The inflation kicker offsets most – if not all – of the earnings drag from higher interest costs,” JP Morgan says.
The sector’s performance also depends on the portion of funding that has been hedged at more favourable rates.
Macquarie says that assuming 70 per cent hedging, the theoretical cost of debt has risen from its low point of 1.2 per cent in December to 3.4 per cent at current spot rates.
“Using market pricing for interest rates, between 2022 and 2024 we estimate up to a 20 per cent earnings headwind from a higher cost of debt.”
The firm adds that the higher cost of debt is also likely to stymie acquisitions and developments.
Meanwhile, UBS’s real estate team contend that if the market is pricing interest rates correctly, the sector’s free funds from operations (FFO) will reduce by 8 per cent in the 2023-24 year, which “implies further downside and … justifies many investors remaining underweight”.
According to Morgan Stanley, the “least desirable” REITs are those with low hedging cover and a higher ratio of interest payments to earnings (low interest cover).
The firm assesses GPT Group, Stockland, Arena REIT and BWP Trust as being “perhaps in the best position”, having a large hedge position and low gearing.
An investor in “real” assets such as shopping centres, toll roads and utilities, the Martin Currie Real Income Fund cites the appeal of Scentre as foot traffic recovers in the late pandemic.
“Strong tenant occupancy trends translate into the power to push up rents as tenant sales grow,” says portfolio manager Ashton Reid. “The company’s recent results demonstrated a strong ability to maintain yields.”
The fund has also reduced its exposure to holders of CBD office assets, such as Mirvac Group and Dexus Group.
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Source: Thanks smh.com