JP Morgan analysts are taking a sterner view, reducing sector valuations by an average 6 per cent given the rising longer-term bond rates on which REIT funding is usually priced.
Inflation-adjusted “real” yields are most important to the sector, as opposed to the quoted nominal rates. JP Morgan notes that real Australian 10-year government bond yields have risen 140 basis points so far this year, to 0.9 per cent, their highest level since 2018.
The firm notes that inflation helps REITs such as Scentre Group, Charter Hall Retail, Carindale Property Trust and Bunnings landlord BWP Trust, which have CPI-linked rent reviews written into their lease agreements.
The owner of Westfield malls, Scentre Group, has annual rent escalators of inflation plus 2 to 3 per cent on many of its specialty leases.
About half of the Charter Hall Long WALE (weighted average lease expiry) REITs’ diversified tenancies are inflation linked.
“The inflation kicker offsets most – if not all – of the earnings drag from higher interest costs,” JP Morgan says.
The sector’s performance also depends on the portion of funding that has been hedged at more favourable rates.
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Macquarie says that assuming 70 per cent hedging, the theoretical cost of debt has risen from its low point of 1.2 per cent in December to 3.4 per cent at current spot rates.
“Using market pricing for interest rates, between 2022 and 2024 we estimate up to a 20 per cent earnings headwind from a higher cost of debt.”
The firm adds that the higher cost of debt is also likely to stymie acquisitions and developments.
Meanwhile, UBS’s real estate team contend that if the market is pricing interest rates correctly, the sector’s free funds from operations (FFO) will reduce by 8 per cent in the 2023-24 year, which “implies further downside and … justifies many investors remaining underweight”.
According to Morgan Stanley, the “least desirable” REITs are those with low hedging cover and a higher ratio of interest payments to earnings (low interest cover).
The firm assesses GPT Group, Stockland, Arena REIT and BWP Trust as being “perhaps in the best position”, having a large hedge position and low gearing.
An investor in “real” assets such as shopping centres, toll roads and utilities, the Martin Currie Real Income Fund cites the appeal of Scentre as foot traffic recovers in the late pandemic.
“Strong tenant occupancy trends translate into the power to push up rents as tenant sales grow,” says portfolio manager Ashton Reid. “The company’s recent results demonstrated a strong ability to maintain yields.”
The fund has also reduced its exposure to holders of CBD office assets, such as Mirvac Group and Dexus Group.
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