Analysts remain cautiously optimistic about Australia’s Real Estate Investment Trust sector (REITs) after the prospect of higher interest rates triggered a double-digit sell-off in January.

A string of positive earnings reports from trusts across the retail, industrial and office space sectors suggest demand is recovering from the worst of the pandemic, they say. The leveraged sector is also less vulnerable to interest rate hikes than it once was after locking in cheap debt that matures in a staggered fashion.

Morningstar equity analyst Alexander Prineas says higher rates are not the “crisis catalyst” they may once have been. Balance sheets are strong and two-thirds to three-quarters of variable-rate debt is hedged against interest rate changes. Many leases are linked to consumer prices and will rise alongside inflation, he adds.

“Yes, there might be a headwind from a higher risk-free rate but at the same time earnings are recovering as we come out of virus restrictions and people go back to CBDs and malls,” he says.

Morningstar’s REIT valuations already factor in higher rates, says Prineas, giving them a buffer in a rising rate environment. Analyst models use a figure of 6% to 8% when valuing REITs under coverage.

The sector was caught up in January’s global selloff as investors repriced assets in expectation of faster than expected rate hikes in the US and Australia. Higher rates hit REIT earnings by increasing debt payments in the highly leveraged sector. They also squeeze valuations by decreasing the value of future earnings, a similar dynamic seen in January’s technology selloff.

The Morningstar Australia REIT gross return index, which tracks 28 entities in the sector, is down 6.4% this year, compared to 1.9% for the broader index, as of Wednesday.

“So far the market has been very cautious and overreacting in some ways,” says Amy Pham, portfolio manager at Pengana Capital’s High Conviction Property Securities Fund. The sector should be less volatile because REIT earnings tend to be more stable than those in the broader equity market, she notes.

"We harp on about long-term investment. But long term does not mean month to month. It’s at least three years.”

Half-yearly reporting season revealed early signs the economic recovery is taking hold, especially in retail and industrials, adds Pham.

Management at retail REITs Vicinity Group (ASX: VCX) and Shopping Centres Australasia (ASX: SCP) guided towards an ongoing recovery in retail foot traffic and resilient tenant sales at their portfolios of shopping malls and retail outlets. Morningstar increased fair value by 6% and 9%, respectively.

Diversified REIT GPT Group (ASX: GPT), a “barometer of the sector”, according to Prineas, said it expected earnings growth of 10% to 12% this year when it reported last Monday. The firm owns a mix of office, retail and industrial space.

Shares in GPT rose 0.6% after reporting Monday before slumping 3.1% in the days afterwards as markets digested a 5% fall in rents amid continued uncertainty about the impact of working from home on office space. Rents are close to bottoming out, says Prineas, who argues the firm is set for growth.

Goodman Group (ASX: GMG) reported statutory profit doubled to $2 billion and upgraded earnings guidance on Thursday as a boom in e-commerce buoyed its portfolio of industrial and logistics properties. Shares ended down 0.08%.

Of the eleven REITs under coverage to report earnings, seven have seen shares prices rise over the subsequent days. Vicinity Centres led the pack, up 13.4% since reporting Tuesday.

Others remain cautious about the prospects for the interest rate sensitive sector. Tom Bodor, an analyst at investment bank UBS, estimates earnings fall 4% for every 1% jump in interest rates.

Opportunities in the sector

More than half of the 17 REITS under Morningstar coverage are trading in a range analysts consider to be fairly valued or better.

Analysts highlight Mirvac (ASX: MGR) as 'undervalued'. The property developer is trading at a 17% discount after reporting a 9% rise in operating profit to $297 million for the six months ended 31 December. Shares dipped when it reported last Thursday before rebounding 2.35% in the days since.

Prineas argues markets are punishing the developer for its focus on residential apartments. Despite fewer investors and less immigration creating challenging conditions, he says Mirvac can expand as Chinese developers exit the market.

Mirvac’s pricing power also means it will be able to pass on rising commodity prices, adds Pham.

Industrial REITs are looking strong, says Pengana's Pham. Vacancy rates are as low as 1% or 2% in Sydney and Melbourne, which should flow through to higher earnings growth. She also believes retail REITs are improving and valuations are bottoming out.

Among those that have reported this month, GPT, Vicinity Group, Dexus, Charter Hall Social Infrastructure and Growthpoint Properties are trading in ranges Morningstar considers to be fairly valued.

Cromwell Property Group is trading at a 15% discount to fair value and will report its earnings to the market next Thursday.