Ridiculous REIT discounts put real estate teams up pecking order

Do you have any idea how you would go about working out whether these NTA values are realistic given the volatility in property prices in the last 3 years?

I feel like the big risk in REIT's or real estate companies is property devaluation and (Possibly, I have no idea, debt/liquidity issues), but have no idea how you would go about researching this.

I think you have to look at individual REITs to work it out. Look for how much of the portfolio has been revalued (Waypoint recently revalued down a lot of their portfolio over the concern so NTA is a bit more reasonable) and others you will need to make some guesstimates.

You can see b some cap rates and the implied from current valuations in the table below from Macquarie. I think you have to accept cap rates are going up (valuations coming down) and work out whether that it is more than in the price. Or just look from a yield perspective given the quality of the portfolio.

There are some positive signs Centuria Office REIT had a good market reaction to their results today up 8%.

Thank you for the fabulous write up @PeregrineCapital.

As a long term holder of various REITS I'm curious to know if you also consider WALE (weighted average lease expiry) in your decision?

Hi Shadow,

I do look at WALE and WARR (weighted average rent review) to help form a view on NOI and maintenance capex (things like lease incentives).

I would say that WALE is a little bit overrated as a metric, it's important to an extent but it's only a small piece of the puzzle, especially when it comes to the large, diversified portfolios that most REITs have.

There are scenarios where a long WALE actually works against an asset. For example some industrial properties are locked into long term leases at rents that are now well below market. This impacts the assets value negatively.

There's also the question of credit and releasing risk. There's no point getting excited about a WALE of 10 years if the tenant is going to go broke 3 years into the lease and the property proves difficult to release (think certain petrol stations, medical or agricultural properties).

Also watch out for "WALE" washing. Some REITs will report increased WALEs but not disclose what portion of that increase is due to new properties acquired during year as opposed to strong leasing outcomes.

For those unaware there is a lot of talk around the divergence in value of unlisted property funds and their listed counterparts (REITs) following a -20% last year for REITs and up to a +20% in unlisted property funds. The gap was so large that APRA is investigating especially the marks in industry super funds - Australian property funds in super: APRA raises alarm on performance gap between listed and unlisted funds (afr.com). People applying/withdrawing at stale prices.

I believe it was listed funds reacting to the increased risk-free rates and somewhat bizarrely unlisted funds shrinking cap rates further. The issue is front page news in the UK following the gating of the Blackstone Property Fund About that $4bn BREIT deal | Financial Times (ft.com) which now spread to others UK property funds facing curbs on withdrawals reach $17.8 billion | Reuters as people rush to withdraw.

Macquarie says:

The Macquarie Macro Strategy Team expect the US to enter recession in 1H23, with the AU economy also forecast to slow. REITs are typically one of the worst performers in the early phase of a recession, and as a result it is difficult to be more constructive in the initial stages of the year. While bond yields are expected to fall into a recession, we anticipate a tightening of credit markets will be a catalyst for a reset in asset values, a reduction in development pipelines and an increased focus on capital recycling. Therefore, we favour defensive names to begin CY23.

Expect better performance in 2H23 driven by shift in rate cycle Positively, as the cycle progresses and central banks ease (which is the base case in the US during 2H23), REITs typically outperform. With the sector trading at a 24% discount to NTA, this implies cap rates will expand by ~100bps (ex. cashflow offsets). While this may reflect spot conditions (i.e., current real rates), if we look beyond the near-term risks to the downside, the top-down environment for real assets should improve (e.g., CB’s easing, softer 10-year yield and improving credit markets). As a result, current REIT pricing could prove pessimistic when looking beyond the volatility, providing opportunities for listed investors and M&A when looking through the current cycle. As a result, we would be opportunistic through the year and upweighting to more cyclical exposures on weakness. 

For my part I think the valuations are probably somewhere in between, meaning unlisted needs to go down and REITs should rise (albeit NTAs will come down) or risk being taken over. From a top-down perspective as shown in the asset class returns, I posted before REITs look interesting on a 3-year outlook - after being the worst performing asset class last calendar year. Some have said that some will need to raise capital due to unhedged interest rate debt and overleverage.

Anyway, what do others think. What REITs or subsectors do people think are most interesting? Best way to play it through an ETF? a fund? a basket? Disagree and think further downside ahead?

@PeregrineCapital said it is a bit more boring sector of the market, but looking at past returns REITs seem to be very volatile which of course creates some good opportunities.

@Mujo actually im surprised at some of these comments, being that REITs have performed poorly and are expected to do so. to me they have been steady esp when add back the high yield. im a seller of reits here but not because they are poor investments (future or past) but i feel we are entering the period of the market (2023) when you should be prepared to add risk to your equity exposure and that to me doesnt mean reits. therefore i have sold down my WPR, HPI and looking at selling CLW and GPT, all these have done ok in a bear market where a lot of growth stocks have halved etc esp o/s. if we have a decent break in the market, which is a real chance at some stage this year i will go more risk on ie will buy growth not reits. thats my view could be wrong

Hi Mujo,

I think that the listed market is approximately right and that the unlisted market is in for some very big revaluations.

With the marginal cost of interest for REITs probably now in excess of 5%, there is simply no way that current book values hold up in the medium term.

Sooner or later the tide will come out (forced selling) and we will see who is swimming naked.

If you are buying REITs on the basis of the discount to NTA, don't.

Low leverage and good management are the way to go.

Chris Joye has been calling this out for some months now - e.g. this in the AFR: Alarm bells ring for commercial property

Back in Nov he commented:

One of the fascinating dynamics in the transition to this new normal where the search for yield is dead is that many asset classes – and the investors who populate them – have yet to face up to the reality of risk-free government bonds paying annual interest rates of 4-5 per cent. Given the Reserve Bank of Australia’s cash rate will likely be around 3.5 per cent in a few months, government-guaranteed bank deposits will be offering similar returns.

Anything riskier than Aussie government debt has to beat that 4-5 per cent yield hurdle – and by a very handsome margin because these bonds are perfectly liquid and risk-free! Put differently, you need to receive extra return compensation for both the additional credit (or capital loss) risk and illiquidity risk. The saying used to go that “there is no alternative” (TINA) to chasing risk. Today there are many risk-free or low-risk alternatives.

A classic example is commercial property. A recent speech from the Reserve Bank of Australia’s Jonathan Kearns highlighted that while 10-year Australian government bond yields had jumped from 1 per cent to 4 per cent, the expected yield on office, retail and industrial commercial property had hardly moved.

This has meant that the return premium you get on commercial property above the risk-free interest rate on government bonds has dropped to its lowest levels on record. Historically, commercial property has paid a 4-5 per cent annual extra yield above Commonwealth government rates. That has recently slumped to 2 per cent or less, signalling that commercial property yields will have to rise sharply.

The only way that will happen is if their values fall sharply, which is what normally occurs in every recession. In fact, there is a reason banks don’t normally lend much to commercial property owners or residential developers: the regulator does not like them doing so because these sectors have been the single biggest bank killers over the last 150 years. ANZ and Westpac almost went bust because of their commercial property exposures in the 1991 recession. The difficulty of accessing bank finance has meant commercial property and residential development owners have had to borrow from non-bank lenders, which will now have to carry this can.

More recently in an interview with Tom Piotrowski of CommSec Chris mentioned something to the effect that unlisted property funds and holders were desperately trying to not value or sell their property assets in the hope that things might turn around before they have to revalue them

The one consideration I like to reinforce is that it's so hard to tell when the market has "priced in" the expectations. Sure, a lot of the REITs have fallen in anticipation of lower asset valuations, higher interest costs, and then some outlook but it seems as though every bloody news article or lower NTA has a tug to the downside and wondering how to tell when that will stop.

It's like the exact opposite scenario of the Qantas SP recovering 12 months before travel even opened up.

Thanks all, appreciate the views.

Some REIT managers/brokers talking their own book of course but the bull view - Real estate investment: top property stocks tipped to deliver 15pc or more after a year of pain (afr.com)

• The S&P/ASX A-REIT 200 index is already up 6.2 per cent this year, nudging ahead of the broader equities market. Last year, the top property stocks slumped 20.5 per cent, underperforming the general market by 19.4 per cent.
• With much of the pain priced into property already, and with the rate rising cycle expected to ease by mid-year, analysts are tipping strong gains in the sector, notwithstanding economic uncertainty.
• “We ... expect a challenging macro backdrop and fundamentals, but A-REITs to outperform in the second half of calendar 2023 as the market gets clarity on rates stabilising, despite an expected economic slowdown,” Jefferies analysts Sholto Maconochie and Ronny Cheung wrote in a client note.
• The stabilising of rates could lead into a “risk on” rally, which would be good news for fund managers such as Charter Hall and HMC Capital, which are likely to outperform. It could also spell danger for mispriced REITs, which would be vulnerable to takeovers, the analysts said.
• “Alternative A-REITs, non-discretionary retail, industrial, and those with strong balance sheets and/or CPI-linked leases should perform well in 2023,” they wrote

“Our least favoured sectors are office, [residential] and discretionary retail. We expect A-REITs to deliver 11 to 15 per cent total return, inclusive of 4.2 per cent yield.”

Some property stocks could deliver even more, according to Jefferies, such as Charter Hall Retail REIT with a 17 per cent total return forecast because of the CPI-linked leases in its malls portfolio. HomeCo Daily Needs REIT could generate similar-sized returns, backed by the resilience of non-discretionary retail shopping.

Barrenjoey analysts led by Ben Brayshaw are forecasting a 12.5 per cent upside to the price targets in their top stocks, with a 5.8 per cent dividend yield on top of that.

Diversified player Mirvac, along with Charter Hall and office landlord and fund manager Dexus, are Barrenjoey’s top picks among the larger REITs.

“Thematically, the commercial real estate cycle has turned, but demand for high-quality assets has not gone from the market,” the Barrenjoey analysts wrote.

“Fundamentals for some sectors are the best they have been for several years, and we continue to see the local market as favourable versus offshore.

“Based on our revised price targets, prospective returns for REITs continue to be as attractive as we can remember.”