This month, Australia’s two largest economies started reopening after months of lockdown, with expectations that it could unleash a wave of consumer spending and people returning to the office.
Will things be back to normal or has the pandemic created structural shifts that the ‘new normal’ is here to stay?
Meanwhile, the backdrop has also changed. With interest rates heading back toward where they were at the beginning of the year and concerns around cost inflation, reduced stimulus and labour shortages threatening to muddy the outlook.
With the market expecting interest rates to rise from these historically low levels, we assess below the impact this would have on AREIT’s earnings and the flow-on effect on cost of capital and valuation.
From an earnings perspective, at first glance one can say that the impact of higher interest rates has minimal impact as the average gearing level for the sector is relatively low at 27%. However, with fierce competition for quality assets, many REITs (particularly the externally managed REITs) have utilised low floating rate debt to maximise the earnings accretion from acquisitions. As a result, REITs’ earnings are now much more exposed to interest rate moves, with more than 35% currently unhedged compared to 20% in the previous year. As an example, Scentre Group (SCG) has annual rent escalations of CPI +2-3% p.a. on a majority of leases. However, with leverage of >40% and historically low hedging levels of 55%, we see headwinds to earnings if interest rates continue to rise.
Currently, the average debt cost for the AREIT sector is 3%, compared to 4% three years ago. The expected rise in rates would make it harder for externally managed REITs to grow through debt-funded acquisitions. The flow-on impact would be a slowing of fund manager’s AUM growth, and more importantly, it will highlight the REITs that are able to grow earnings through capital recycling and development compared to those purely relying on acquisitions.
On valuation, the AREIT sector has, for the past 10 years, benefited from falling interest rates supporting cap rate compressions.
Going forward, as rates start to rise, we see a slowing in cap rate compressions and a catch-up in rental growth, particularly for favourable asset classes such as logistics. Our valuations assume a 3.5% bond rate which is 1% higher than the market. This provides us with a buffer in the event of further rate rises. The average forecast distribution yield of the sector is currently 4%, providing a 195 basis point yield gap to 10 year bonds that should continue to provide support for the AREIT sector.
So how is the Fund positioned? We remain positive on the outlook for fund managers (Charter Hall Group (CHC) and Centuria Group (CNI)) and residential developers (Cedar Woods (CWP) and Peet Ltd (PPC)), particularly in land sub-division, and we continue to increase our exposure to the alternative sector with our recent take up of the newly listed RAM Essential Services Property Fund (REP), taking our total exposure to the alternative sector to 25%.
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