Key Points: 

 

  • Higher interest rates are delivering a hit to Real Estate Investment Trusts (REITs) due to high debt levels and falling property valuations. 
  • However, strong tenancies provide predictability of earnings, with rental growth built into lease terms.
  • Top picks in the sector: Mirvac, Dexus and GPT.

 


Read about the pros and cons of investing in REITs vs. direct real estate.

Trancript: 


Alexander Prineas: The higher interest rates are hitting pretty much all the REITs because they do have higher debt than a lot of other more cyclical companies. So, they get hit with higher interest costs. Plus, the higher discount rate from higher interest rates impacts the valuation of companies with more long-dated earnings. So, by the same token, they do also have that predictability of earnings. They have a very strong list of tenants, all the major REITs have and there's very few in there that we expect would default. Even in a recession, for example, the REITs generally are able to get some earnings growth from improving we leave the pandemic behind, plus a little bit of rental growth built into the leases to offset some of those interest rate rises.

The office space, yes, it's tough. Rents did come down a long way, but we seem to be seeing a bit of a stabilization there. In some areas, they're rising. And then, I'd also point out that the REITs tend to have a lot of the best-quality office. So, a lot of that pain in terms of vacancy in the office space is being felt in the more suburban areas or in the lower-quality buildings, whereas the REITs tend to own those A grade and premium properties in the CBDs where there is still some demand.

In, say, the retail property trusts or retail REITs, if you look at the neighborhood or convenience malls, your local shopping center, about half the tenant base for those names is the big supermarkets like Coles, Woolworths, ALDI. And so, that's your neighborhood or convenience REITs like Charter Hall Retail REIT or region group. And then, if you look at the more destination malls, like the Westfield Centres that are owned by Scentre Group, or for example, the Chadstone Shopping Centre in Melbourne that's owned by Vicinity Centres, they also have a lot of exposure to the supermarkets. They also have brands like Kmart, Louis Vuitton, JB Hi-Fi. Those discretionary retailers may suffer more in a recession, but they still have to keep paying the rent. Typically, there's rental growth built into those leases. That's on the retail side.

So, if you think about a lot of those big office REITs, so things like Dexus. Mirvac and GPT, they are focused on the CBD, the prime assets in the CBDs, and those are typically tenanted by the likes of the big banks. Also, the large listed companies that have their head offices in the CBDs around Australia, particularly on the eastern seaboard. We also note that a lot of those big modern CBD office buildings tend to have the best energy ratings and the best environmental ratings. They're the most modern buildings that are suited for hybrid working. So, we are actually seeing reasonable demand for those types of buildings, but we are seeing much higher vacancy in some of that older building stock. And so, we do think the major REITs are pretty well placed. And in particular, the office REITs, the major office REITs generally screen as undervalued to us at the moment.

I've mentioned Dexus, GPT and Mirvac as all being undervalued names. And then, I'd probably particularly single out Mirvac because not only does it have one of the best and most modern office portfolios in Australia, it also is one of the best-known residential housing and apartment developers. Now, you might think well both these areas are under pressure at present, but a lot of the valuation is about the long-term earnings and we're actually seeing good long-term fundamentals for Mirvac. So, for example, on the residential side, we've got very strong population growth. We've got a significant physical shortage of housing as evidenced by the low rental vacancy rates across Australia, and we're also seeing a lot of residential developers go out of business who don't have a strong enough balance sheet or who don't have the capability to manage costs and project complexities in this current difficult environment. So, if anything, the long-term outlook for Mirvac is improving as some of the weaker competitors exit whereas Mirvac unlike a lot of other developers it integrates all the way from design, construction to development and sales of the finished product, particularly on the apartment side. So, we see Mirvac as very well placed and significantly undervalued.