Beaten-down REITs are ready to shineby Dylan Coker, July 23,...

Beaten-down REITs are ready to shine
by Dylan Coker,
July 23, 2022 08:31
Better times could be coming for real estate investment trusts as a worsening economic outlook raises the appeal of defensive stocks, according to Macquarie analysts.It has been a tough calendar year for the REIT sector which has fared 10 per cent worse than the S&P/ASX 200 Index as long bond yields climbed in response to inflation worries and rising interest rates.Listed property may yet shine again as investors turn to defensive assets amid economic gloom. And in the short term, there could be more bad news heading into earnings season as property chiefs address the effect of rising borrowing costs on their balance sheets and the prospect of falling valuations.But there could also be opportunities if the macroeconomic environment turns for worse, Macquarie analysts have written in a client note.With the risk of a US recession rising, bond yields could moderate, easing the pressure on the REITs, according to Macquarie. But the bank includes the proviso that credit spreads – the difference in yield between bonds of similar length but different quality – do not widen.“A more subdued economic growth outlook driving greater emphasis on defensive stocks with income certainty would be a positive for the A-REITs in light of the sector’s recent derating,” the Macquarie analysts wrote.
The valuations of bond proxies such as infrastructure, utilities and real estate, typically take a hammering as long bonds are sold off and their yields rise. Equally, as the Macquarie team notes, a decline in bond yields “has traditionally resulted in the REIT sector outperforming the broader equity markets”.Falling 10-year yieldsWhile the REIT sector has underperformed the broader market by 10.3 per cent this calendar year, much of that weakness occurred between March to June, when the 10-year bond yield jumped from 1.7 per cent to 4.2 per cent. Over July, as bond yields eased back to 3.4 per cent, the sector has outperformed.With the outlook for the global economy weakening,
Macquarie expects the US 10-year note yield to fall to 2.25 per cent by the end of next year, with the yield on the Australian 10-year treasury easing down to 2.5 per cent.“Provided a recessionary event does not coincide with a material widening of credit spreads, this should result in a reduction in borrowing costs, aiding the performance of the real asset classes such as REITs, in our view,” Macquarie analysts wrote.Property stocks with greater earnings certainty, such as shopping mall owner Vicinity Centres, industrial powerhouse Goodman and childcare centre landlord Arena REIT are favoured by Macquarie. Its analysts are steering clear of REITs with “greater downside risk to balance sheets and earnings” including Westfield operator Scentre Group, Charter Hall Long WALE REIT and Dexus Industria REIT.
Rising rentsWhile the REIT sector has taken its medicine early, speculation has moved on to whether values in the direct commercial property market will be the next to fall. Rising rents are one obvious offset to any pressure on values, a point Jefferies analysts have also noted.“The real estate free money ride is over, with low yields needing to be vindicated by rental growth,” Jefferies’ Sholto Maconochie and Ronny Cheung write in their reporting season preview.“We, therefore, prefer quality stocks with strong balance sheets and rental growth, which sees us favour Goodman and defensive non-discretionary retail that benefits from supermarket inflation.”
Jefferies picks include mall owners SCA Property and HomeCo Daily Needs REIT along with office landlord and fund manager Dexus, given its exposure to the Sydney office market, its stock’s heavy discount and its take over of AMP Capital’s real estate funds platform.With all the uncertainty over growth in earnings and asset values, investors and analysts will be paying extra heed to balance sheet strength, free cash flow, and debt costs during the upcoming reporting season.
To that checklist, Jarden analysts, led by Lou Pirenc, added some hot topics, such as which asset classes – childcare, long-lease properties, retail, manufactured housing estates – will prove to have the most robust rents.As well, given the uncertainty over the cost of capital there will be more questions asked about deal-making. Large acquisitions are `getting harder to stack up and development margins are coming under pressure, according to Jarden.And the wild card could be the prospect of M&A activity, particularly as valuations come under pressure.“With so much [global] consolidation in other yield and real asset sectors, we are often asked whether we will see more sector consolidation,” the Jarden team wrote.“At current valuations, we believe the risk of consolidation is real and could start providing support for the sector, but our ratings continue to focus on underlying performance.”