May 19, 2020 | Pete Morrissey
1. Why have the distribution rates for the Australian REIT funds been cut?
Australian landlords are facing reduced earnings because rents from their tenants are falling, due to enforced closures or shutdowns due to social distancing. Aventus and Scentre Group, for example, have both cancelled their dividends altogether. All real estate is being impacted to some degree with only a few tenants, including supermarkets and hardware stores, benefitting.
Because we’re receiving less income from the AREITs in our portfolio, we have less income to pass on to our investors. The question is one of magnitude and time; what proportion of forecast earnings will be lost to the pandemic and how long will it endure?
We expect the impact to be greater than a 10% fall in earnings across the sector in the second half of 2020. This is primarily due to the lockdown in March and much of the June quarter. We also expect the first half of the next financial year to be affected, although mostly in the September quarter. As a result, earnings for the next financial year will be lower than previously forecast.
Our response has been to reduce the distribution rate by 20% in the APN AREIT Fund (and 15% in the Property for Income funds), effective May 2020, to be paid on 10 June 2020. This, we believe, will give us the capacity to absorb the forecast earnings reductions this financial year and next.
This reduction has been implemented with the view that no further cuts will be required, although obviously the situation is fluid. After this cut, the APN AREIT Fund features a running yield of 7.18%1.
After more than 11 years of paying a consistent distribution rate, we didn’t take this decision lightly. However, we believe this is the only prudent approach to manage investors’ best interests, protect capital and ensure the Fund is able to provide a sustainable distribution for the long term.
2. Are AREITs a buy?
The sector rebounded 13.7% in April but still has a long way to go to recover from the 35% fall in March. Given the uncertainty around the removal of social distancing and the speed of economic recovery, some investors are clearly staying on the side lines to see how things will play out.
While the impacts of COVID-19 have been more tangible and immediate for real estate, we believe it is on the road to recovery, although prices do not yet reflect that. AREITs remain attractive in our view.
3. After falling so sharply, can AREITs still be described as “defensive”?
Aside from events like the global financial crisis (GFC) and Covid-19, real estate has typically enjoyed a lower beta than broader equities. This means AREIT share prices tend to be less volatile than other stocks. Whilst this meets the defensive criteria, in March this was clearly not the case. AREITs were especially hard hit.
The pandemic has been a once-in-a-century event, or at least we hope so. We believe it is inappropriate to judge an asset based on its short-term performance when faced with an exceptional event such as this. No asset class will perform the same way under all market conditions, especially when facing an event like this. It is, however, generally true that AREITs are more defensive than other listed stocks under most market conditions due to the higher income and lower growth composition of their returns.
The sector’s future recovery and performance will ultimately determine whether AREITs continue to deserve their defensive status. We think they will. The foundations of Australia’s prosperity were built on high-quality real estate. Long term, the pandemic and its aftermath is unlikely to fundamentally change the role that commercial property plays in commercial activity.
4. Why have Australian REITs been hit harder than GREITs or Asian REITs?
Primarily due to the prevalence of Westfield shopping centres, Australia has a higher retail component in its REIT sector than other countries. Our market also features very high ownership by offshore investors, many of whom have been attracted by the higher yields the local market provides.
These two factors explain the indiscriminate selling that occurred among REITs in general and retail-orientated REITs in particular. A plummeting Australian dollar no doubt also hastened the decision for offshore investors to sell.
Even so, the extent of the fall in AREITs compared to other sectors in Australia and REIT markets around the globe was stunning. Only now is the market beginning to put that right with foreign investors beginning to return. Frankly, we were grateful for the opportunity. For those focused on the long term, AREITs have returned 11.6% p.a. over the decade (2010-19) underpinned by a 6%+ distribution yield.
5. How do you see the retail sector changing after COVID-19?
The first thing to understand is that retail is always in a state of flux. New concepts come and go every year, which means that the sector is more adaptable and innovative than it is often given credit for.
In recent years, though, retail has faced some difficult headwinds. Declining residential property prices and weak wages growth have fed poor consumer sentiment whilst online retail has grown in popularity, something that has been accelerated by the lockdown. Some of the online consumer trends that have emerged under COVID-19 are likely to endure.
But the crowds returning to shopping centres prior to Mother’s Day indicate the social and enduring nature of the centres themselves. The COVID-19 impact on retail is yet to be fully understood but good retailers will evolve to meet the challenges, as they have always done. And those that fail will be replaced by new retail concepts, again, as they have always done.
6. Do you expect office sector demand to fall?
Working from home will become a viable option for some small and medium-sized enterprises whilst others will recognise the productivity and collaboration benefits office space provides.
Many employees miss the social interaction of an office while modern work spaces and building facilities are critical to attracting high-quality staff. This is likely to continue. The social component to our collective working lives is often understated and there are many employees that can’t wait to get back to work, nor their bosses to have them back.
The wave of post COVID-19 business innovation will be a source of new demand and social distancing may also require tenants to provide higher floor space ratios for staff. Whilst it’s possible the demand for office space will fall as working-from-home becomes more common, it’s also possible that overall demand may not change as much as many investors believe.
7. What are you buying, holding and selling right now?
We’ve reduced our exposure to discretionary-focused retail landlords such as Scentre Group and Vicinity whilst increasing our exposure to non-discretionary landlords like Charter Hall Retail REIT and Shopping Centres Australia. Both have higher earnings stability, driven by exposure to supermarkets.
Our holdings in convenience retail and service stations have been increased along with industrial. We expect earnings in these sectors to be minimally impacted by COVID-19. These changes were made with a longer-term view of delivering on the Fund’s income and risk objectives.
8. Where are property valuations going?
That depends on the sector and asset type. Retail values have been under pressure for some time and we expect further falls to come. Neighbourhood and convenience stores should continue to do well but weaker sub-regional shopping centres face reduced earnings and higher vacancy rates. Unsustainable centres might be converted either partially or in full into alternative uses.
Values in the office sector are likely to vary, depending on location and tenant quality. Low vacancy rates provide support, but declines are likely given that office values are at historic highs in Sydney and Melbourne.
Metro market valuations are supported by lower rents, which will be attractive to cost-focused businesses. As for industrial assets like logistics and data centres, they’re relatively expensive, although investor and tenant demand mean valuations are unlikely to fall by much, if at all.
1. As at 14 May 2020. Current running yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.