Thursday, June 7th, 2018
Private investors and SMSFs who do not have the balance sheet to acquire a direct property often choose to buy listed Real Estate Investment Trusts (REITs) as a proxy for their property exposure.
Listed REITs generally have portfolios of high quality capital city properties with a weighted average lease expiry (WALE) of more than four years. Their leases feature high quality tenants with rents that typically rise in line with consumer price inflation (CPI). An investment in listed REITs can be converted to cash in two days, as opposed to the several months required to buy or sell a property plus its associated expenses such as stamp duty and agency fees. In both cases we believe the time horizon for the property asset class to be many years as part of a long-term investment strategy.
Listed REITs release their net tangible asset (NTA) value every six months, generally based on independent, external appraisals. Rental leases, property location, potential for redevelopment all affect the NTA but the most important single variable is the capitalisation rate that has been used.
Since the Global Financial Crisis (GFC), there has been strong investor demand to acquire high quality assets with attractive yields to try and match investors’ liability profiles. Naturally, such liability profiles will rise with the long-term inflation rate.
Global bond yields bottomed in July/August 2016 and have risen sharply since then. US Government ten-year yields bottomed at 1.4% and are currently trading above 3% while domestically, Australian ten-year rates bottomed at 1.8% and are currently trading at 2.8%. After a sustained period of decline, both US and Australian long-term bond yields appear to be moving higher. Similar rises of around 1% in government bond yields have occurred in most other western government respective bond markets. The clear exception is Japan, where seemingly entrenched asset buying programs (quantitative easing) continue unabated.
What may be of concern to listed property investors is that this rise in the risk-free rate over the last two years has not (yet) translated into any rise that these portfolios are using for their capitalisation rates. Market prices across many A-REITs, on the other hand, have meaningfully adjusted over calendar year 2018, pre-empting a potential increase in these published cap rates.
The change in the NTA can be quite considerable on even a 0.5% rise in the capitalisation rate. For example, if Aventus Retail Property Fund (ASX:AVN) lifted this rate by 0.5% from their December 2017 NTA of $2.34, current NTA would fall to $2.08. Under the same scenario, Charter Hall Long Wale REIT’s (ASX:CLW) NTA would drop from $4.02 to $3.53, Dexus Property’s (ASX:DXS) NTA would fall from $9.16 to $7.82, Westfield’s (ASX:WFD) NTA would fall from $5.99 to $5.12 and Vicinity Centres (ASX:VCX) would drop from $2.93 to $2.59. Across the aforementioned names, this equates to an average decline in NTA of -12.8%.
To illustrate this point, below is the capitalization rate of Vicinity Centres graphed against the ten-year yields from Australian & US bond markets. We believe this contrasting direction over the last two years cannot continue in the long term. Thinking of it another way, the cap rate spread over the bond yield has narrowed despite no significant change in the risk profile of the underlying property portfolio. It is difficult to view this change as sustainable and we believe some form of mean reversion is inevitable.
Figure 1. 10-year bond yields vs. VCX cap rate
Source: Thomson Reuters, Bloomberg & VCX reports
Figure 2. Retail cap rates, Sydney and Melbourne
Source: JLL Research (via Deutsch Bank)
At this stage in the cycle and based on continuing strong investor demand for quality properties, there will be pressure on valuers to maintain their current capitalisation rates. However, if global bond yields continue their upward rise we believe it will become increasingly imprudent for these capitalisation rates not to also rise, leading to commensurate fall in the REITs sector’s NTA’s.
Despite the above potentially challenging outlook for those traditional ‘rent collecting’ A-REITS, we remain positive on Stockland (ASX:SGP), Elanor (ASX:ENN) and Folkestone (ASX:FLK) which we believe can deliver underlying earnings growth within their broader businesses, and hence be more resilient, in what we see as an inevitable period of declining NTA.