In this latest insights piece, Marcus Ryan, Deputy Portfolio Manager, details why appealing A-REIT opportunities are now beginning to emerge in owners of resilient retail portfolios which currently trade at steep discounts to Net Tangible Assets. While the near-term could be bumpy, we’d rather be early than miss a potentially compelling thematic.
For only the third time in 20 years, passive A-REITs now trade at 25-30% discounts to net tangible assets (NTA), significantly below their long-term averages (-1%).
However, with the obvious challenges facing the sector – higher interest rates are pressuring the consumer – and declining valuation concerns now priced in, there are several supporting factors which are driving our more optimistic outlook.
1. Average 20% declines in asset values appear excessive
In the face of higher interest rates, which are yet to flow through to book valuations, passive A-REITs trade -28% below NTA (refer Chart 1) implying ~20% falls in gross asset values. While that’s arguably fair for the Office sub-sector (vacancy levels have already tripled to 15% in five years[1]), Industrial assets enjoy persistently strong rental growth from outstanding fundamentals, while Retail has already materially de-rated post-COVID.
2. Dividend income remains attractive
Dividend yields of ~6% are attractive for the first time in many years (refer Chart 2). While higher interest rates will likely drive some A-REITs to re-base dividends, we believe current share prices provide a margin of safety. In our view, dividend growth is set to re-emerge faster for those REITs with lower gearing and with leases exposed to CPI escalators, providing a partial and effective income inflation hedge.
3. Monetary tightness will not persist forever
In our view, interest rate sensitive sectors like A-REITs stand to benefit alongside the inevitable return of stable/declining interest rates. Calling the timing of such is difficult, but history builds a convincing argument on the importance of being positioned ahead of time.
4. Divergence (and fear) brings opportunity
With performance bifurcation likely across the sector, remaining selective will be key. This means actively avoiding: (i) A-REITs with excessive financial leverage; (ii) lower quality asset owners (who face elevated income and valuation risks); and (iii) property fund managers with earnings well above mid-cycle levels.
The evidence shows A-REITs as the most ‘unloved’ sector on the ASX today. Outside of the banking sector, domestic active equity managers are positioned most underweight A-REITs (with consensus overweight positions in IT and Industrials[2]).
Where are the best opportunities today?
We currently see material upside to broader sell-side rating expectations in several ‘out of favour’ REITs. Vicinity is a good example: only 1 of 13 brokers today rates the stock a ‘buy,’ compared to six brokers only 12-months ago[3].
In our view, the more appealing opportunities are emerging in owners of resilient retail portfolios trading at steep discounts to NTA. In particular, we favour Vicinity (VCX), Region (RGN) and Stockland (SGP) (refer Chart 3).
A number of factors support these three particular stocks.
Firstly, retailers and mall owners have started this consumer downturn in a healthy position and with strong foundations to navigate a challenging period ahead. As higher interest rates continue to squeeze consumer wallets, specialty retailers today generally have strong starting point balance sheet positions (Net Debt / EBITDA ~1.0-times) while A-REIT VCX’s modest gearing levels (25.7%) compares favourably to total passive-peers (32.0%) and retail-focused passive-peers (33.6%)[4].
Secondly, the shopping mall industry structure is supported by effective negative net future supply (per capita basis). Importantly, mall portfolios are effectively ‘full’ (97%+ occupied), tenant retention levels have been rising, bricks & mortar has continued to ‘win-back’ market share from online retailers (their 10% share of total sales today is down one-third from the COVID-peak).
Lastly, Retail asset valuations face notably less downside than Office. While we continue to expect some weakening into the Dec-2023 period, we note $50bn of REIT property valuations released for 30 June 2023 have thus far revealed an average de-valuation of -4.0%, embedding -7.2% for Office, -3.5% for Retail and -1% for Industrial assets[5].
While we are still underweight the sector overall and expect further devaluations to emerge through the August reporting period, we believe the risk-return has finally swung positive on a medium-term view and have recently initiated new A-REIT positions across our large cap equity portfolios.
[1] YCM, JLL, Macquarie Research, July 2023. Melbourne prime vacancy 16.6%, Sydney prime vacancy 14.9%
[2] JP Morgan, Fund Manager Survey, June 2023.
[3] Refinitiv Eikon, July 2023.
[4] YCM, Macquarie Bank Research, Company data, July 2023. Basket of passive retail A-REIT stocks: CQR, HDN, RGN, VCX, SCG
[5] JP Morgan, Australian REITs Valuation Snapshot, June 2023.