FIIG’s dedicated in-house Research team recently covered the FY23 reporting season, updating clients on the credits we currently trade. The insightful and relevant updates help clients to better understand their portfolio positions and what to expect from the issuers in FY24. Here we look through one such report on the outlook for Australian REITs.
Background
With over 20 years of experience collectively, FIIG’s Research team has covered many reporting seasons and listened in on many investor calls. As the recent FY23 reporting season draws to a close, the team has analysed the results of over 30 credits that are traded at FIIG and produced over 20 reports that have been sent out to clients.
The detailed reports provide insight into the overall performance of the respective companies over the given period, the metrics for performance or lack thereof, and the outlook for the next period. They’re crucial in helping clients to better understand which credits sit in their fixed income portfolios.
There are also ad-hoc updates throughout the year and issuer-specific announcements the team covers. Some of the FY23 updates included Qantas, Lendlease, Judo Bank, as well as a sector overview on Australian REITs, which includes Charter Hall, Stockland, and the like. Here we provide an excerpt of the Australian REITs piece.
Australian REITs update
Over the last few weeks, the Australian real estate investment trusts (REITs) released their results for the period ending 30 June 2023 (FY23 or 1H23, depending on the reporting cycle). The results were published with a sense of anticipation, anxiousness, or confirmation given the high level of publicity the commercial property sector has faced in light of the current macroeconomic headwinds, both cyclical and structural. Granted there have been so many publications and market reports written about commercial property over the last six months or so, we have tried to simplify all the noise to provide an overview of the REITs performance and outlook. At a high level, the results came largely in line with our expectations, both in terms of earnings and revaluations.
We have broken this report into three sections to help paint a picture of the current operating environment. We first discuss the revaluations seen over the last six-to-12 months and the key reasons for this across the traditional sub-sectors (office, industrial, and retail). This is then followed by an overview of the current actions being put in place by the REITs to help offset any further potential headwinds. Finally, we analyse credit metrics to determine their short-to-medium-term outlook, where we reiterate our view that major wholesale downward changes of credit ratings remain highly unlikely. Ultimately, while the current dynamics are clearly of greater relevance for the equity markets (especially given the focus on share price versus net tangible assets, the latter being heavily influenced by asset valuations), fixed income investors are rightly more focused on cash earnings which have continued to show solid stability.
Devaluations have (finally) arrived
Since mid-2022, asset valuations have been expected to come under pressure given, more generally speaking, supply and demand characteristics, lower property trading volumes, and the impact of rising interest rates (driving capitalisation rates). It appears that this prediction arrived during the recent reporting period. Figure 1 shows the weighted average book value of office, retail, and industrial assets amongst eight Australian listed REITs (Dexus, Mirvac, GPT, Charter Hall LWR, Scentre, Stockland, Centuria CIP, and Centuria), along with the change in valuations as a percentage of book value. We note that the change in absolute book value doesn’t fully mirror the change in valuations, because book values also incorporate incentives, capital expenditure, acquisitions, and developments, amongst other metrics.
Figure 1: Weighted average revaluations, FY18-FY23 / 1H23
We see that office and retail properties experienced sharper valuation declines in FY23/1H23 at -7.2% and -2.3% respectively. Industrial assets also saw a fall for the first time in over five years, albeit very marginal at -0.2%. This is likely a reflection of three factors. The first is the increase in interest rates and capitalisation (cap) rates. The latter describes both the income a REIT earns divided by the book value of its assets and the return an investor expects from investing in REITs.
These have moved quite sharply over the recent period, a reflection of higher capitalisation rates and the operating environment. In our view, the softening of cap rates should have occurred earlier, given the headwinds facing the sector were known as early as last year, although we recognise that valuers may not react as quickly given they not only rely on moves in macroeconomic data but also on actual transaction values (which were few and far between until recently).
The second is how the market views these sectors, with the emerging thematics (mainly in office and retail) leading to some concerns regarding stresses faced by tenants and landlords, subsequently leading to the prospects of lower rental income generated by REITs and lowering values.
The third is the influence of market transactions. For example, Dexus sold its 44 Market Street tower in June at a 17.2% discount to book value, which has ultimately set a benchmark for future valuations in the office sector. It also made an unconditional sale on another office building (1 Margaret St), in line with the FY23 book value but at a 21.4% discount to FY22 levels. This partially explains why the office sector saw the largest negative valuations across all REITs over the last 12 months, and in our view, has the least constructive outlook.
Outlook from updated rating triggers
We have undertaken a few exercises to help rationalise the potential impact on the bonds of each respective REIT our clients are currently trading.
To begin with, each of the companies still retain solid investment grade ratings with a large buffer above the ratings associated with sub-investment grade. As such, we reiterate our view that a wholesale wave of multi-notch downgrades across the sector is highly unlikely and we remain confident the rated issuers covered in this report will retain their investment grade ratings. We don’t discount however the possibility of outlook changes (to ‘Negative’ from ‘Stable’ – which can typically be interpreted as a 1-in-3 chance of a downgrade over a two-year period), and at worst, we might see a one (or, in a worst-case scenario, two) notch downgrade for some if pressures subsist.
In terms of the likelihood of this event, there appears to be some more pressure for some issuers as the table below shows (Figure 2). As of June, around half of the issuers are in breach of their earnings triggers (which could constitute a ratings movement), but rating agencies would typically act only in the event of a prolonged deficiency with no realistic prospect of improvement. Typically, rating agencies would first change the outlook and wait for potential corrective actions (or a rebound in performance) before moving to an outright downgrade.
Figure 2: S&P / Moody's REIT ratings triggers
Gearing ratios (generally determined by dividing the total debt by total tangible assets) have started to increase which is probably not surprising given lower book values across the sector. This can impact the performance of a REIT for a few reasons. First, higher gearing can translate into higher borrowing and interest costs, which in turn reduces earnings. Many market participants have noted that these costs are quickly becoming the largest expense for landlords given the larger amount of debt (compared to other sectors) and higher funding costs (from rising interest rates).
Second, the terms of all the respective notes for the issuers incorporate a gearing ratio covenant that is required to be maintained at all times. No REIT is in current breach of its internally-set ratios, and remains well below covenant levels. For these to be breached (which would constitute an Event of Default and see the price of the respective bond plummet), equity (or book value) would have to fall by around 47.4% on average (with the lowest at 33.8% for Centuria CIP). Even the most pessimistic analysts would find this hard to believe, considering we saw declines of 25% for prime-grade office assets (one of the most affected sectors) during the Global Financial Crisis.
Conclusion
We admit that this sector appears to carry more headline risk than others at present given the structural shifts occurring in workplaces and shopping preferences, and this can be seen in the respective share prices of the (listed) issuers which are still trading at discounts to their net tangible asset per share. Obviously, the market still believes there is a weakness to come and will be drawn out over a longer period. All in all, REITs are definitely not out of the woods yet.
Despite this, we continue to take comfort from the credit-related aspects as well as the diversified portfolios of these REITs. Covenants have not been breached (and we expect this to continue), gearing remains below internal targets (and can be eased with corrective action), and they retain solid investment grade ratings, meaning the likelihood of significant losses of capital is remote.
