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Finding value in the Australian Real Estate Investment Trust (A-REIT) sector is hard work. Falling interest rates and the hunt for yield have sparked A-REIT outperformance this year.
The S&P/ASX 300 A-REIT index has a total return of 23% (including distributions) over one year, S&P Dow Jones Indices data shows. The ASX 200 is up almost 17%.
Over 10 years, the A-REIT index’s annualised return of 11.5% compares to 7.8% for the ASX 200. Care is needed with index comparisons: the market-weighted property index is influenced by some large A-REITs, but the case for long-term property exposure remains compelling.
A-REITs and other so-called “bond proxies” historically outperform the share market when bond yields fall and underperform when they rise. Lower rates reduce interest costs and underpin higher property valuations.
Also, falling rates encourage income investors to buy higher-yielding investments, such as A-REITs, utilities and infrastructure stocks. With another rate cut or two likely in the next six months – and Australian rates unlikely to head higher anytime soon – the “yield trade” in A-REITs has further to run.
That’s the good news. The bad news is that the sector’s underlying fundamentals are mixed. Interest rates are at a record low because Australian economic growth is moderating. A weakening economy inevitably leads to softening tenant demand, easing rents and slower growth in property values.
Retail A-REITs, such as owners of major shopping centres, are facing anaemic consumer spending, growth in e-commerce, and department stores and other anchor tenants cutting back on or exiting space. The risk is lower retail rents when shopping-centre leases are reset.
I still believe “fortress malls” – premium shopping centres in premium locations – have latent value in Australia. They have significant competitive advantages because of their scale and position and some, such as Chadstone Shopping Centre in Melbourne, are almost becoming mini-cities with office, hotel and residential developments (at other centres).
Retail A-REITs such as Vicinity Centres (VCX) and Scentre Group (SCG) arguably offer the best value in the sector at current prices because so much bad news has been factored into their price. They could surprise as contrarian ideas in 2020, but it is too soon to buy them yet, given the retail malaise.
Residential A-REITs such as Stockland (SGP) and Mirvac Group (MGR) have rallied over one year, up 46% and 52% respectively (on a total-return basis). Although Australia’s residential construction recession is deepening, the market is projecting a worsening future housing shortage and has sharply re-rated Stockland and Mirvac, whose operations extend beyond residential property.
I nominated Stockland and Mirvac as key ideas for The Switzer Report in May 2019, in “Contrarian buy and sell ideas for the New Financial Year”. Stockland has rallied from $3.70 to $4.78 since that story and Mirvac from $2.80 to $3.20.
I like the long-term prospects of both stocks, given Australia’s projected population growth and rising housing demand. But Stockland in particular has run too far, too fast for now and looks fully valued. I can’t buy either A-REIT after their gains over the past 12 months.
Most property investors I know have favoured commercial property over residential and retail in the past 12 months. However, growth in demand for new office space in the largest capital cities hit a four-year low in August 2019, according to Property Council of Australia data.
So, the A-REIT sector has outperformed the broader share market and parts of the sector have soared this year, even though underlying property fundamentals have mostly deteriorated.
A-REITs are a beneficiary of this crazy low-rate environment, which is driving up asset prices and encouraging investors to overpay for assets with higher yield. Don’t get me wrong: A-REITs are a terrific sector and the best ones have important defensive qualities. Rather, beware buying the A-REIT sector aggressively at these levels, even after recent weakness this month.
I scanned more than 30 of the largest A-REITs for this story, using a combination of my own analysis, broking research and consensus analyst estimates. I passed on nearly all of them. Many traded at a premium to their net tangible assets (NTA) and looked overvalued.
I found better value in the smaller A-REITs that focus on a niche such as self-storage, childcare centres, education properties or convenience retail. I have nominated niche A-REITs previously and some, such as Arena REIT and BWP Trust, have starred. Here are three smaller A-REITs worth following at current prices:
The owner of Australian childcare centres has been one of my core A-REIT ideas for the past few years. Arena’s total return over one year is 44% and the annualised three-year return is 22%.
I like Arena for three reasons. First, its exposure to childcare, a long-term growth industry. I prefer getting exposure to childcare through property owners rather than childcare-centre operators, which tend to be more volatile and have a habit of destroying capital. Arena is also expanding in health properties, another attractive, defensive sector.
Second, Arena has been a consistently good income stock. At $2.98, it is yielding 4.5%. Arena has grown its distribution from 8.8 cents a unit in FY14 to 13.5 cents in FY19 and has good prospects for continued steady growth in this area.
Third, Arena has a smart strategy and is well managed. The trust chugs along each year, adding centres and generating high occupancy rates and solid rental growth. I like smaller A-REITs with discipline and consistent performance; too many have tried to grow too quickly over the years.
Arena is not cheap after gains this year. Morningstar values it at $2.73 a unit against the current $2.99. Valuations are always relative: many other A-REITs I looked at for this story are trading at far higher valuation premiums, in riskier sectors. Arena’s price gains will probably be slower from here, but it remains a solid holding for long-term income investors.
Prominent property investor APN Funds Management launched APN Convenience Retail REIT through an Initial Public Offering in July 2017 at $3 a unit. AQR now trades at $3.43.
I wrote favourably about AQR in early July 2019 because it is an interesting play on convenience retail at petrol stations. The stock has edged higher in the past few months.
AQR owns 71 properties around Australia. Most of the petrol stations are located on key roads in capital cities or highways and tenants include Puma, EG Group, 7 Eleven and Viva Energy Australia. Major tenants account for nearly all of AQR’s portfolio income.
I like AQR’s strategy on several fronts. Strategically located service stations and convenience retail facilities in capital cities are hard to replicate. As Australia’s population grows and more cars are on the road, tenant demand for these service stations will rise.
AQR has a long-lease portfolio (77% of income expires in FY30 and beyond) and averaged contracted annual rental growth is 2.9%. Convenience retail is reasonably defensive: people still need to buy fuel and are likelier to maintain small food and drink purchases at convenience retail outlets when the economy slows. It’s a lot less volatile than discretionary retail at fortress shopping malls.
AQR has a healthy balance sheet with gearing at 32.3% in its FY19 result and interest cover at 4.2 times, meaning it has capacity to acquire other stations and steadily add to its portfolio. A 6.1% yield at the current price is another attraction.
As a small-cap A-REIT, AQR suits experienced investors. The stock has rallied more than 10% since June as the market re-rates its prospects and better understands the long-term growth prospects of convenience retail in Australia.
APN Convenience Retail REIT
The self-storage operator has had an average 12 months, on the market at least, by its standards with a 13% total return. After strong early gains after its 2014 IPO, National Storage REIT had edged higher in the past three years as some brokers questioned its growth prospects.
NSR’s earnings-per-share (EPS) growth of 9.6 cents for FY19 was at the low end of its guidance (9.6-9.9 cents) and FY20 guidance of no less than 4% EPS was given. NSR also announced a $170 million equity capital raising to fund storage-centre acquisitions.
NSR acquired $235 million of assets in the second half of FY19, well above its previous $60-$100-million target, according to brokers. Thirty-five centres were acquired in FY19, and eight acquisitions, worth more than $100 million, are due in FY20.
The market might have expected stronger growth from NSR given its acquisition spree and a bit more detail on acquired assets, to provide greater clarity on its earnings growth.
The long-term thematic for NSR is firmly intact: Australia’s growing population and capital-city densification will increase demand for self-storage space. That’s been the experience overseas and Australia’s self-storage industry remains highly fragmented. NSR is rapidly acquiring assets as the industry consolidates, to build its market position and grow its economies of scale.
The market has mixed views on NSR. An average share-price target of $1.58, based on the consensus of five brokers (too small a sample to rely on) suggests the stock is overvalued at the current $1.83. Macquarie Group values NSR at $1.25. Morningstar values it at $1.77. NSR’s latest published net tangible asset (NTA) per stapled security was $1.63.
Long-term investors should watch and wait for better value in NSR, preferably buying it closer to NTA. It would not surprise if NSR underperforms a little in the next 12 months as it digests all these acquisitions. Long term, NSR has a valuable position in an attractive niche in the property industry and is rapidly building its portfolio through well-executed deals.
An expected 5.5% yield might attract dividend investors, but there could be volatility in NSR’s price given the market’s divergent views on the stock. Better to stand aside for now and put NSR on the portfolio watch list: there’s latent value in self-storage assets, at the right price.
National Storage REIT