High-risk signs for high-yield A-REITs

Yield is starting to look expensive. Assets paying a relatively higher yield than what investors can get in the bank are being sought after, but often without factoring in the inherent extra risk or volatility.

It is not hard to understand why investors receiving only 3% or so from a bank term deposit may consider investing in Australian Real Estate Investment Trusts (A-REITs), which have a return as a sector of more than 5%. Indeed, some individual A-REITs are yielding more than 7%.

But sources of higher yield come with higher risk and volatility, and a recurring theme to remember is that there is no free lunch with respect to returns that promise to be higher than the market average – whether from bonds, hybrids, shares or A-REITs.

A-REITs, as I discussed last week in A-REITs: Building income returns, can provide a bond-like return in delivering a steady reliable income stream. But the return or distribution, which currently is similar to the grossed-up yield of the sharemarket, may come with share-like volatility, due to rising correlations of returns of A-REITs with shares over the long term.

A-REITS have higher longer-term volatility than non-REIT shares, due to the massive sell-down during the global financial crisis.  Before the GFC period A-REITS generally were less volatile as they were considered conservative, paying a reliable income stream to investors.

But the relatively stronger yields paid by some of the A-REITs should not be viewed alone, without reference to other factors such as macroeconomic indicators and bottom-up indicators that are qualitative and quantitative (see Table 1).

Table 1: Investment factors for REITs

What investors should look for in A-REITs

Investors should particularly focus on A-REITs that meet all three of the following factors:

Low debt to equity ratio

The average gearing level of the sector is around 47% at the moment. Gearing above that may suggest that the company can find it more difficult to service its debt, especially when interest rates rise. Also, there is the concern that stapled companies (which involve a trust holding the assets of one or more companies) may be participating in higher-risk activities that could be outside the core activities of property investment, as we saw in pre-GFC days.

Discount to net tangible assets (NTA)

A discount to NTA is the best scenario, meaning the price paid for assets is less than the independent valuation. In 2012 discounts of nearly 20% to NTA were considered good value for A-REITs, but that was after these companies reached ridiculous NTA premiums of up to 80% before the GFC. Today almost all A-REITs in the S&P ASX 300 A-REIT index are trading at premiums to their NTA. Also, in the current environment with a strong run-up in prices of A-REITs and premiums to NTAs, a discount to NTA may suggest some uncertainty about future earnings. But, as A-REITs have historically traded at a premium, a current premium under 11% (the long run average premium) may still suggest reasonable value.

Payout ratio – 90% or less

A-REITs must pay out 90% of earnings to meet the tax-free status guideline. But a higher payout ratio may suggest that the company is using debt to pay for distributions, or is paying out too much and not retaining sufficient funds for the maintenance and improvement of its properties.

Other factors for consideration

• The percentage of total income that is from rental income.
  Investing in an A-REIT should involved investing in a security that provides regular income from rent – the reliable recurring income that investors are seeking.  Due to their stapled structures, many A-REITs may be earning income from other businesses such as fund management or non-core property development. I believe that the main reason for owning A-REITs is to own good-quality commercial property that which provides a rental return, which otherwise would be inaccessible to a retail investor due to the high purchase price of commercial property.
• Non-core operations that are apart of the stapled structure, and how do they fit into the overall operations.
  Some A-REITs are focusing on growing, for example, their fund management operation, which may not be a direct beneficiary of rental income and may increase investors’ exposure to volatility of returns.
• Geographical location of properties
  Prior to the GFC many A-REITs invested into offshore property. A-REITs found they needed other sources of returns due to the high payout ratios being paid pre-GFC, and the decreasing supply of domestic property, to meet the high returns required. But in many cases the investments were made into properties outside the management’s expertise due to their overseas location.
• Tenants
  High profile, strong brand name tenants are likely to be enduring.
• Quality of the properties
  With respect to ongoing maintenance and likely appeal to good quality tenants.
• Outlook for the sub-sectors
  (Retail, office, or industrial), based on the outlook for the economy.

Higher yielding does not mean quality

In the following tables I have focused on the top five yielding A-REITS. Few are close to meeting the first tests that I consider most important: low gearing, low premium to NTA, and a sustainable payout ratio.

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A-REITs sector outlook

The sector outlook is important to the growth of future earnings from rental income and high occupancy rates. 

The improved outlook for the property sector has been driven by the increase in consumer sentiment. The residential market has staged a strong pick-up in performance as a result of historical low interest rates, albeit with some recent weakness, but most A-REITS are not exposed to the residential property market.

Other sub-sectors, such as retail property, are expected to do better on the back of improved consumer sentiment, despite some short-term weakness blamed on the weather and the recent federal budget. 

Retail

Not all retail property is created equal. Strip shopping and second or third ranking shopping centres are likely to suffer as hurdles, such as online shopping, grow. This will force some small retailers to shut, and replacement tenants will be difficult to find (see Robert Gottliebsen’s article Lighten the retail property load. Major shopping centres, such as Chadstone and Doncaster Shoppingtown in Melbourne, Chatswood in Sydney, and other similar high calibre shopping centres, should not be affected in the foreseeable future.  The quality of their tenants, the location of their centres, and length of their leases will support their ongoing performance.

Office

The office sector continues to see increasing vacancies in most major cities, and new supply is likely to cause a drag over the next few years. This is especially the case in Sydney, with about nine years of office space available from 2015-2016.

Industrial

Industrial space has been in high demand, with some large transactions in the market, but the weaker outlook for some areas of manufacturing may hinder performance. 

Conclusion

Good-quality A-REITs that have a superior property portfolio, low levels of debt, a small premium to NTA and pay a yield higher than the broad market are becoming more difficult to find.

The reasons for investing in A-REITs include:

• Accessibility to large-scale commercial property.
• Liquidity as they trade on the ASX.
• Relatively low transactions cost compared to direct property investment.
• Diversification, as an investor can own a single A-REIT that holds a diversified property portfolio, and the small investment amount required can allow investment in more than one A-REIT.
• Low maintenance and management costs compared to direct property investment.

The ongoing search for higher-yielding investments has resulted in less bargains in the A-REIT sector, compared to a couple of years ago. 

Share price gains are less likely, as most A-REITs are trading at premiums to their NTAs. The higher-yielding A-REITs may continue to be well sought after, but this may come with higher risk and volatility, due to higher levels of debt, premiums to NTA and unsustainable payout ratios.