Reporting season defies critics, delivers on income

In the last five years (to 31/8/16) the ASX AREIT index (200 Index) has delivered a total return of 19.5% p.a. compared with 9.7% p.a. for the ASX200 Index, an impressive return for a supposedly mundane sector. Some commentators are alarmed at the rise, believing it presages a fall. The recently completed reporting season however, challenges that view. The results were generally in-line with expectations with some notable flourishes, including solid overall earnings guidance and very strong NTA growth in some cases. Rather than detract from it, the results support current AREIT pricing. There are three strands to the “AREITs are stretched” argument:

1. Interest rates are set to rise

The impact of low interest rates on borrowing costs and capitalisation rates have driven AREIT share prices up. Should interest rates rise, the sceptics argue, that beneficial effect will quickly reverse. What are the chances of that happening? Low, at least according to the bond market, where, despite recent increases, US 10-year Treasury bonds still yield far less than 2% and the Australian equivalent only slightly more. Bond markets expect rates to be low for a very long time. Those that disagree with this view are betting against the combined wisdom of the world’s biggest liquid market, effectively telling investors to forget about the risk free rate altogether. That’s a challenge to logic as well as finance theory.

2. AREIT earnings growth isn’t attractive compared with other sectors

The second strand asks an income-focussed investor to compare AREITs, where earnings growth is a modest 3-4% a year, with the banks, which pay a nice, fully-franked yield and have more potential to deliver higher earnings growth. The rebuttal is based on risk rather than returns. Because bank profits can fluctuate, the dividends they pay are less predictable than AREIT distributions. For investors that value regular income, owning the property tenanted by a bank locked into paying rent for many years offers a more reliable income stream than owning shares in the bank itself.

3. AREITs trade at a 30% premium to NTA (as at 14/9/16)

Applying the price-to-net tangible assets (NTA) ratio to the AREIT sector suggests it carries a 30% premium to NTA. But this measure is misleading due to the impact of stocks like Goodman Group and Westfield, which generate substantial earnings from their funds management and property development divisions. The premium to NTA ratio for these two stocks is 50% and 80% respectively. Collectively, they represent more than a quarter of the AREIT index, distorting the overall market pricing premium to NTA. Add in the fact that some property valuations are based on limited historic sales evidence and it’s easy to see how price-to-NTA is a problematic way to measure relative value.

A better way

Whilst NTA is a consistent, independent “assessment” of an entity and the market value of its assets, the trajectory of NTA growth is more useful than any price comparisons. In the last 12 months NTA sector growth rose 11%. That’s a key takeaway from this reporting season. Retail property rent growth of around 3% (JPM data) over the year adds to the solidity of the sector. That figure, too, supports current valuations. Leasing spreads are also generally improving (meaning lease renewals are negotiated at higher rents), vacancy rates remain low and managers are pointedly suffering short term dilution by selling higher yielding (inferior quality) assets to achieve longer term growth, a strategy we heartily endorse. In commercial real estate, office remains the bright spot, especially in Sydney, where limited supply and strong demand are lowering vacancy rates and increasing rents. Attractive income growth of around 4.0% (JPM data) over the year is expected to strengthen in coming years in the Sydney market and, to a lesser extent, Melbourne. Perth and Brisbane office markets remain problematic but are a small part of AREIT portfolios. As for the smaller industrial sector, it delivered weaker growth of around 1% (JPM data) over the year consistent with our expectations given the low growth environment. Lower interest rates and disciplined borrowing also reinforced the sector’s attractions. Higher asset values have reduced gearing levels to around 28.5% (debt relative to gross assets), increasing the ability of AREITs to pay interest expenses. In summary, interest rates generally remain low while rents have grown. Of course, there were some points of weakness in some of the stocks that reported – a few will be challenged by higher vacancies and additional lease expiries in coming years – but none were a surprise, although our long held caution on development risks was again borne out. Westfield Corp revealed that the return on a couple of assets under development will be negatively impacted by elongated development programs or reliance on lower quality earnings. But none of this detracts from the bigger picture: this was a reasonable reporting season that indicates AREIT prices are fair rather than stretched. APN’s confidence in our ability to deliver relatively high income plus some capital growth with a lower-than-market risk has been bolstered by the latest results. Share prices have their ups and down but for long term, income-focussed investors, AREITs remain an attractive proposition. 

 

This article has been prepared by APN Funds Management Limited (ACN 080 674 479, AFSL No. 237500) for general information purposes only and without taking your objectives, financial situation or needs into account. You should consider these matters and read the product disclosure statement (PDS) for each of the funds described in this article in its entirety before you make an investment decision. The PDS contains important information about risks, costs and fees associated with an investment in the relevant fund. For a copy of the PDS and more details about a fund and its performance click here. To receive further updates and insights from the APN team, sign up for Review, our monthly email newsletter.