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Inflation won’t slay REITs

Anthony Fensom  |  08 Dec 2021Text size  Decrease  Increase  |  
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The bugbear of inflation is looming large again, threatening to wreak havoc upon traditional “bond proxies” such as real estate investment trusts (REITs). Yet not all REITs should be treated equally, with many still showing upside potential despite rising interest rates, according to Morningstar.

Australian REITs have bounced back from COVID-19 to be among the top sector performers in 2021. After suffering a coronavirus-linked market shock in March 2020, ASX-listed property funds and individual stocks have rebounded to post annual gains exceeding 30% on the back of low interest rates, an improving economy and rising stock market.

The benchmark S&P/ASX200 A-REIT, which tracks the performance of Australian REITs and mortgage REITs, recorded year-to-date return of nearly 17% as of December 7, outperforming the broader S&P/ASX200 index, which was up 9.4%.

Among property ETFs, the SPDR Dow Jones Global Real Estate Fund (ASX:DJRE) showed a year to date rise of 33.8%, while the VanEck FTSE International Property (Hedged) ETF (ASX:REIT) increased by 23.3%.

Meanwhile, Australia-focused property ETFs also posted high returns, including the Vanguard Australian Property Securities Index ETF (ASX:VAP), up 15.3% year to date.

Individual REITs to have produced strong gains include Charter Hall Group (ASX:CHC), up 29.5% and Goodman Group (ASX:GMG), up 28.7%.

Yet with inflation starting to rise, analysts suggest REITs could revert to their pre-coronavirus returns of around 9%, with income generating a large proportion of the gains.

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Slowing global liquidity could also crimp performance as central banks start turning off the tap, while the threat of lockdowns has returned due to the recent Omicron variant of COVID-19.

In its December 7 meeting, the Reserve Bank of Australia (RBA) left its official cash rate steady at 0.1% noting that underlying inflation was still low at 2.1%.

“A further, but only gradual, pick-up in underlying inflation is expected. The central forecast is for underlying inflation to reach 2.5% over 2023,” the RBA said.

Steven Goakes, managing director of unlisted property fund manager Natgen, says the fixed rate interest market suggests a long-term increase of around 2%.

“As supply chains recover, the expectation is that the recent inflation spike will normalise and long-term inflationary pressures will return closer to pre-pandemic levels,” he says.

"This accords with the RBA's current commentary and no doubt official interest rates in the future will be based on this. Whether official rates reach 2% in this cycle, only time will tell."

Earnings recovery

Morningstar equity analyst Alexander Prineas says higher interest rates matter for the REIT sector, but that the level of sensitivity isn’t as high as it once was. The first issue for the sector is valuation, he says.

“A lot of REIT share prices are still below their pre-COVID-19 levels, even though they’ve had a strong rebound,” he says.

“There’s also a growing recognition that they shouldn’t be priced as bond proxies since their earnings are more unpredictable.”

Prineas points to the prospect of an earnings recovery for many REITs, as coronavirus restrictions ease, borders reopen and workers gradually return to the office.

“I’d prefer to avoid those ‘priced to perfection’ sectors that may not necessarily benefit as economies reopen. For REITs, while rising interest rates will be negative, they’ll also have a tailwind from earnings recovery,” he says.

He also noted the importance of analysing the reason behind rising interest rates. Higher inflation driven by wages growth could be beneficial for retail-focused REITs, since this would “put money into people’s pockets, especially low- and middle-income consumers who have a higher marginal propensity to spend.”

The logistics sector is also enjoying gains due to the optimisation of supply chains and the shift to online shopping during lockdowns, although this factor could ease as COVID-19 worries gradually subside.

“Arguably, the logistics sector is fully valued, whereas the retail and office sectors are more likely fairly to be slightly undervalued,” he says.

Prineas also considers REITs to be well prepared for any rate rises, with most having staggered debt expiries and moderate levels of gearing, making them “not as vulnerable as they have been in the past.”

US research also suggests that rising interest rates “do not necessarily lead to poor returns” for REITs. REITs produced positive total returns or outperformed the broader S&P 500 index in four of six periods since the 1970s when 10-year US Treasury bond yields rose significantly, according to S&P Global analysts Michael Orzano and John Welling.

“Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher,” the analysts conclude.

“If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.”

Preferred exposures

Australian investors eyeing the listed property sector could consider some of the “undervalued” stocks that have the potential for gains, according to Morningstar’s Prineas.

He refers to developer Lendlease (ASX:LLC), rated four stars by Morningstar but with a high uncertainty rating.

“Lendlease has had issues not only with COVID causing construction delays, but also their engineering business. However, with virus restrictions now easing and the company having sold its engineering business, it has a bright future, particularly offshore,” he says.

“Lendlease has a lot of developments in key gateway cities around the world. It could sell down stakes in these projects to capital partners and become more of a fund manager, which would make future earnings lower risk and potentially earn a higher multiple from the market.”

Similarly, four-star rated Unibail-Rodamco-Westfield (ASX:URW), one of Europe’s largest listed retail REITs, is considered undervalued, albeit with a high uncertainty rating.

“Unibail-Rodamco-Westfield is priced at a discount to the physical value of its assets, yet it has been selling assets in line with their book value,” Prineas says.

“We think there’s an opportunity there for investors, as the market recognises the value of its assets.”

The four-star rated Ryman Healthcare (NZ:RYM), an owner and operator of aged care and retirement facilities, has been able to push through price increases due to rising property values, Prineas says.

“The typical model is residents sell their house and then move into aged care or a retirement village, so there’s a strong correlation between house prices and the value of their portfolio,” he says.

“While rising construction costs have hurt, Ryman’s construction challenges should also moderate as borders reopen and lockdowns ease,” he adds.

For 2022, Prineas expects mixed performance from the REITs, with the main winners to be those with the prospect of stronger earnings growth.

“I don’t think you can generalise – some REITs are still priced as bond proxies whereas others have issues,” he says.

“However, in an environment where you’re looking at potential reopening but also where interest rates are rising, I’d rather be in stocks where earnings have some potential to recover compared to those where the earnings haven’t been interrupted at all.”

is a Morningstar contributor.

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