From Morning star.

A-REIT valuations largely unaffected by rising rates so far; sector looks undervalued.

Alexander Prineas

Australian listed property trusts trade at substantial discounts to net tangible assets (NTA). The magnitude of the discounts implies a looming commercial property correction, or even a crash.

At the time of writing, diversified landlord and residential developer Mirvac (MGR) trades at a 24% discount to its 31 December 2021 NTA, and a 32% discount to our $3.10 fair value estimate. Dexus (DXS) trades at a discount of 21% to NTA and 14% versus our fair value estimate. Many REITs trade on similar discounts, noting some own intangible assets that are not included in the NTA calculation, but are valuable. For example, narrow-moat DXS has a funds management business, and no-moat MGR has a residential development business, the latter we believe is worth circa 50 cents per security.

During the COVID-19 lockdowns, a key risk for REITs was debt covenants linked to earnings. These include interest cover requirements, which means a REIT’s earnings need to exceed interest payments, typically by at least 1.5–2.0 times. With REITs unable to collect rent from locked-down tenants, this was a risk.

Earnings are recovering, but there is now the risk of covenants linked to asset prices being breached. These covenants typically include constraints such as limits on debt/asset ratios. If commercial property asset values fall as rates rise, overindebted REITs could be forced to sell assets or raise equity in weak markets.

Despite this, we have maintained our fair value estimates for REITs under our coverage. We had already factored in higher debt costs, typically assuming a long-term cost of debt of roughly 6%, varying slightly by name. Apart from a few highly leveraged names with gearing above 40%, such as Cromwell (CMW) and Unibail-Rodamco-Westfield (URW), Australian-listed REITs under our coverage have balance sheet gearing (net debt/assets) below 35% as at 31 December 2021. Furthermore, our intrinsic valuations are typically already below respective NTAs.

Reassuringly, some REITs have announced preliminary valuations for 30 June 2022, showing physical asset values were holding up so far, despite higher interest rates.

Mall operator Vicinity Centres’ (VCX) preliminary revaluations indicated a 1.7% uplift in book values over the half year to 30 June. A strong recovery in retail conditions contributed to capitalisation rates, essentially a yield number, used to value commercial property, tightening from 5.35% to 5.31%. CEO Grant Kelly said income growth was a predominant driver of the uplift, and the guidance update “largely reflects the sustained strength of retail sales and improved negotiation outcomes with retailers, and therefore stronger than expected cash collections in respect to current and prior years.” VCX also upgraded its earnings guidance, now telegraphing funds from operations (FFO) of at least 12.6 cents per security, up from its previously stated range of 11.8 to 12.6 cents.

Neighbourhood mall operator Shopping Centres Australasia (SCP) also revalued its property portfolio in June, revealing a 1.4% valuation uplift. Despite higher interest rates over the course of the year, SCP noted its cap-rates tightened from 5.45% to 5.43%. It also recently purchased some neighbourhood malls at a 24% premium to the book value of the vendor, Centuria Capital Group.

Office REIT DXS also revealed updated valuations, seeing its book values climb 2.2% over the six months to 30 June.

Admittedly, we take these valuations with a grain of salt, noting there have been few commercial property transactions in the recent quarter on which to cross-check the NTAs. Activity has ground to a halt, with buyers seemingly holding out for better prices, and sellers anchored to high prices seen in transactions earlier in the year. The result is a standoff, and our expectation is that buyers will eventually benefit from lower prices.

We continue to monitor the risks and remain watchful for any evidence of a possible disorderly unwind. Even so, this uncertainty appears to remain far from the market’s fears of rapidly widening cap-rates implied in the current security prices, which would be needed to crash commercial property. The fact 30 June valuations have held up seemingly gives REITs another six months in which to get their affairs in order should tougher conditions eventuate. We expect some cap-rate widening and ensuing pressure on NTAs, but we expect this to be partly offset by further leasing progress on vacant assets, and construction progress for development projects underway. While it varies by name, the recent correction has pushed many names in the REIT sector into fairly valued or undervalued territory.

Interesting discussion. I hold a few REITs in my SMSF, specifically:

GDC: focussed - only sort of a REIT, it's a digital infrastructure fund (so data centres etc.)

LIC: focussed - owns / operates retirement villages

SGP: diversified - commercial, office & business park, logistics, and residential & retirement communities

WPR: focussed - service station and convenience stores

I also own some units in the unlisted Centuria Healthcare Property Fund which is focussed on, you guessed it, health care properties.

I'm considering ditching WPR, and SGP I could take or leave to be honest. But GDC, LIC, and Centuria Healthcare I'm happy with and plan to hold for years. They all have strong technological (GDC) or demographic (the other two) tailwinds behind them, they all operate in niches which provide a moat of sorts (new entrants would need to build expertise over time to compete), and they are not particularly affected by movements in the residential property market, or by how the "re-opening" goes.

I did look hard at CIP and I like the outlook for industrial property, but I couldn't bring myself to buy after the massive run up in early 2021. Just looks a bit pricey to me, and I don't think the outlook for industrial property is that much better than any of the other stuff I hold.

@PeregrineCapital , I couldn't agree more with your comments :

Given I have no idea about what will happen to interest rates or inflation my strategy has been to avoid baking in aggressive earnings growth into my valuations and give preference to REIT's with low debt levels. REITS which have relied on low interest rates to produce insane growth in funds management income should be avoided.

The above-mentioned sentence summaries the vanity of REITs . My wife manages a big-box store , and the traffic is very low . We can argue about location , buyers preferences etc

The fundamental problem is how many products a person is willing to buy / buying habits . There is a high degree of cognitive dissonance between the ACTUAL growth rate vs EXPECTED return in retail environment . I recall Peter Switzer's stories about Adairs - how great the stock is , online sales model, marketing strategy blah blah .

Here's the 5Y chart :

I've been to many facilities/Industrial Parks owned by Goodman , and the business model is very solid ( integrated logistical/office facilities ).

Back in Feb 17 , GMG's EPS growth was projected to be 20% compared to FY21 , almost double HY profit and the list of good news goes on . The problem is that stock price reached all times high , and now in downtrend . Morgan Stanley's price target was $27.88 , Citi $29.50 , Jefferies $27.79 .

Here's the current price :

Not sure if this is the right time to invest in REITs to be honest .

MMM some good points above. In saying that I would prefer GMG over most other Reits as they seem well managed. My thought are that GMG is well positioned when it comes to the oline market gaining share on retails sale which is meant to expand in the long run considerably.

In saying that, we are also experiencing a shortage of supply in most areas relating to imports from China etc. My wife owns a Homewares store and cant get many items at the moment with no dates provided on arrival times. She has also noted other Homeware stores all selling the same items that usually have points of difference in there stocked items, again this tell us there is only whats in the country for stores to stock. This could mean that Industral storage may not be needed as much as they cant get stock to fill them, or maybe they need more storage so they can maintain stock levels to keep business turning over. We saw Kogan do this recently and ended up with to much stock and increased costs due to extra storage.

Still I see industrial warehouse storage (Goodman) as the better one over office space Reits . Aslo Stay away from Retail. Scentre Group (Westfield) looks quiet compared to what it used to be. Late night (Thursday) shopping is really quiet. I know a Manager of a Country Road store that said there takings are way down across the state (Foot traffic in Westfield and other centres most noticably) I think peoples habits have changed with regards for the need to spend. Two years of Covid broke some well intrenched habits. Makes a case for online spending right.