Real Estate Investment Trusts (REITs) have been in steady recovery since the GFC. Debt levels have improved to more sustainable levels. However, we can’t ignore some risks have been on the rise while others have fallen. This article explores these risks and ways of potentially managing them.
The most recent crisis which culminated in 2009 had its roots in the build-up of gearing and high valuations. Chart 1 shows in 2008 some Australian REITs (AREITs) were amongst the most highly geared, with a median debt-to-enterprise value (EV) of 80%.
Since the GFC, balance sheets have been repaired – even though the motivation of REIT companies to increase gearing has remained, with the “siren sound” of low interest rates playing, thus far in aggregate they’ve resisted the temptation.
Fortunately, as gearing levels declined, the sector’s performance improved with the S&P/ASX AREIT Accumulation Index and FTSE EPRA/NAIREIT Developed World Index now exceeding pre-GFC highs. Chart 2 shows the Australian REIT market’s performance over the last decade.
Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.
With the index returning to peak levels, valuations across the sector are again stretched. The return expectations for REITs are close to the lowest levels seen over the last 15+ years.
Even with considerably lower debt levels, REITs still remain a relatively highly leveraged sector – global REITs (GREITs) and AREITs remain geared to more than twice the level of other industry sectors – and thus will always be more sensitive to changes in interest rates. Therefore REITs have much higher correlations to bond markets than the broader share market.
The negative correlation between REITs and US bond yields is of particular concern given US government bond yields are close to historic lows and the market expectations are for them to rise. To put this into context, using our research models, we would expect a 1% increase in bond yields to drive a 17% decline in AREITs and 19% decline in GREITs.1
While valuations and sensitivity to bond yields are of concern at the index level, a manager that has a wide array of property companies and markets to choose from may be able to reduce these risks through diversification.
A challenge to the promised stable returns of the real estate sector is nothing new. The oversupply of commercial real estate that followed financial deregulation in Australia in the late 80’s, Tokyo in the early 90’s, Hong Kong prior to the Asian Financial Crisis in the mid 90’s, Ireland during the GFC and Perth at the end of the recent resources boom are all examples where the predictable returns offered by property have failed to materialise.
Importantly, what have been considerably rarer than real estate busts, are busts that impact all geographies and all property sectors at the same time. Leading up to the GFC, after the US and Tokyo real-estate indices began to decline in 2006, Australia hung on until November that year and the Shanghai property index resisted until January 2007. More recently we’ve seen Perth’s residential property prices decline, while Sydney and Melbourne have continued to appreciate.
An approach which invests only in the Australian market is challenged in finding these opportunities, with the index becoming more concentrated over recent years. Obviously the AREIT market is more exposed to Australian economic outcomes than GREITs, and it is very dependent on the outcome for Australia’s retail sector as well. 50% of the AREIT index market cap is in retail. 10 years ago it was only 35%. In the global index retail only makes up a third. Almost half the AREIT index is concentrated in only three companies. For passive AREIT investors this means they are exposed to a very narrow set of outcomes; while they could be favourable, and the companies that dominate the index have delivered good results recently, it raises the risk. The AREIT Index is not very risk/return efficient.
Source: Bloomberg. Data accessed March 2017.
In a broad universe the active REIT investor has the best opportunity to find the parts of the real estate cycle that still offer attractive returns despite the obvious headwinds. Even a passive approach to global real estate resulted in more muted drawdowns during the GFC than AREITs due to the diversification across multiple regions and real estate sectors.
We reflect this view in our asset allocations with our REIT managers given the opportunity to select their assets from those listed globally, as well as Australia. After all, it really only makes sense to compare Australia’s REITs to their global peers when two out of three of Australia’s biggest listed property companies, Westfield and Goodman have a significant portion of their assets located overseas.2
1. Any projection or other forward looking statement (‘Projection’) in this document is provided for information purposes only. No representation is made as to the accuracy
of any such Projection or that it will be met. Actual events may vary materially.
2. Bloomberg, as at 31 December 2016.
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Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Any projection or other forward looking statement in this publication is provided for information purposes only. No representation is made as to the accuracy of any such projection or that it will be met. Actual events may vary materially.
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