The last three months have seen a dramatic rally in the AREIT sector as Australian 10-year bond yields came down from highs of 1.9% in late February to 1.5% currently, providing a tailwind for the yield-sensitive real estate sector.
Having fallen as much as 35% in the trough of the 2020 pandemic, the AREIT market rallied following the positive vaccine news later in the year, as markets rotated towards value and sought “re-opening trades”, thereby driving a strong recovery in the sector.
The recovery however has not been universal. With structural shifts continuing to put pressure on large retail malls and offices, performances were mainly driven by the industrial/logistics (GMG +45%), funds management (CHC +64%), and residential development sectors (SGP +49% and INA +39%).
With the Real Estate sector being so strong, investors may ask where to from here? There are several key factors to consider;
1) Lower for longer? For many years (since the GFC), the market operated in a low-interest rate and low growth environment. This was a supportive environment for real estate investment with rental yield being sought after. With the significant amount of fiscal and monetary support injected into the economy due to the pandemic, it is not surprising that inflation picked up. The question continues as to whether this spike in inflation will be sustained over the medium term and whether central banks are willing to raise rates in response to it. The recent commitment from the RBA to keep rates at 0.1% until at least 2024 and the tapering of bond purchases, had led to the yield curve flattening (ie 10-year bond yields retracing from the highs of 1.9% to 1.5%). The market is interpreting this move by the RBA as a reaction to the strength of the economy and the need for further emergency monetary settings is starting to recede (which is very different from potentially raising rates to contain inflation). Importantly, with the sector offering an average forward distribution yield of 3.8%, providing a yield gap of 230 basis points to the 10-year bond yield, we see continued support for the sector.
2) Is listed real estate a good inflation hedge? It can be argued that property provides a natural hedge against inflation as most commercial leases incorporate annual rent reviews of at least CPI. However, this only covers the component of the sector that are pure rent collectors. REITs with more active earnings such as developers and contractors are most exposed to input cost inflation as raw materials and labour costs rise. We are focused on developers that have pricing power such as those with industrial and residential development that can offset this by rising revenues.
3) COVID recovery. The decrease in COVID-19 cases globally could be a function of continuing vaccine roll-outs. However, the more contagious Delta variant of coronavirus places countries with low vaccination programs at risk. As experienced during the month, most parts of Australia have been placed under lockdown as the COVID delta strain continues to spread. This will keep policymakers more cautious in terms of removing stimulus and opening-up of economies, at least until herd immunity is reached via vaccination programs.
4) Changing landscape. As structural and secular trends are disrupting the Retail, Office, and Industrial sectors, these trends are also supporting the emergence of alternative Real Estate sectors. In Australia, alternative sectors are at an early phase, making up only 6% of the benchmark compared to more mature markets such as in the US and UK where they comprise more than 50% of their respective benchmarks. Structural shifts from e-commerce have seen the renaissance of the industrial sector as demand for warehousing and logistics has boomed, whilst new technology-serving opportunities (data centres and towers), urbanistion, and an aging population have driven demand for assets such as childcare centres, affordable housing, and retirement living. We believe that investing and researching into these growing alternative sectors at this initial stage will give us a comparative advantage over our competitors.
Overall, we see a continuation of divergence in performance within the Real Estate sector. The upcoming reporting season will provide more visibility of earnings, particularly in the Retail sector with the unwinding of income support related to COVID-19 during 2020. Our investment process continues to favour REITs with good management, strong balance sheets, and favourable thematic drivers or long Weighted Average Lease Expiries (WALE) to provide sustainable earnings growth. As a result, our Fund incorporates both growth and defensive investments with more than 20% of the Fund’s exposure in alternative sectors.
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