Australians have long viewed residential property as the cornerstone of wealth creation. Yet while direct property investment becomes arguably less attractive due to softer housing markets and new tax headwinds, listed property trusts (REITs) offer exposure to property assets at discounts to their assessed value.
Listed property trusts (REITs) allow investors to purchase a share of rental income from a portfolio of properties bundled together. Much like ETFs, REITs provide investors with easy access to rental income without needing to directly purchase and manage property assets. They also provide some diversification benefits across property sectors and locations, helping reduce concentration risks associated with owning a single property.
Valuing REITs
Our research commonly cites the ‘price to net tangible assets’ (NTA) for REITs. Net tangible assets are simply the value of a REIT’s property portfolio minus any debts or other liabilities. Comparing a REIT’s share price to its NTA provides a useful gauge of whether the market believes those assets are worth more or less than their reported value.
As such, a discount to NTA (price/NTA below 1.0) may suggest investors have concerns about property values, the sustainability of rental income, funding costs or broader economic conditions. REITs on the ASX have traded at a significant discount to NTA over the past few years. This is due to cyclical reasons as well as structural changes in the Aussie property market.
How interest rates and bond yields tie into REIT valuations
A key element of REIT pricing is interest rates as income investors would weigh the relative attractiveness of a REIT and a 10-year Government bond. The bond is considered much less risky, so the investor expects a higher return or yield from the REIT (for taking on more risk). During COVID, historically low interest rates and subsequently low bond yields made average REIT yields far more attractive.
However, the recent rate hike cycle by the RBA to manage inflation meant bond yields closed in on REITs, driving wider discounts as investors demanded higher yields. Some investors are more willing to take on additional risk through REITs when bond yields are lower. The chart below highlights how the rate cycle and futures implied yield curve both act as headwinds for REIT pricing.
Attractive yields vs. stretched balance sheets
Morningstar equity analyst Yingqi Tan explored the environment for REITs in her recent Industry Pulse. Looking top down, the highest yielding REITs in our coverage are Office REITs, which also carry the highest debt levels.
Intuitively, this signals the market is demanding a larger risk premium for lower quality fringe office portfolios with higher levels of debt. Investors can sometimes fall into the trap of chasing the highest yielding REITs in hopes of better returns. However, a depressed trading price can artificially inflate the yield, so investors must consider factors such as the balance sheet and quality of assets inside the REIT before investing.
Yingqi points out that there are compelling yields in high quality, diversified REITs with lower debt levels. Among these REITs include Charter Hall Long WALE, Charter Hall Retail, Dexus Industria, Dexus, Stockland and Mirvac, all yielding around 6%-7%. The chart below highlights each REITs yield against Government bonds and their Price to Fair Value estimates (right hand side of the chart).
Why listed property could be back in focus
The appeal of listed property has historically ebbed and flowed with the broader economic cycle. The backdrop facing investors today may be changing again. Interest rates have been stubbornly high while the RBA combats inflation.
However, if inflation deaccelerates and rates subsequently fall investors may start taking notice of REITs offering yields well above Government bonds. Increased demand for REITs can drive prices higher, closing the discount to NTA and creating a capital gain for unit holders.
At the same time, Australia’s traditional focus on residential property is facing new challenges. Although the Aussie residential property market has been losing steam, Yingqi notes investors may be overestimating the tax reforms long run impact on dwelling prices.
While recent reforms remove advantageous tax benefits for direct property investors, it doesn’t solve the structural undersupply issue in Australia. Concerns surrounding housing prices have been a key reason for the underperformance in residential REITs. No-moat Stockland and Mirvac now trade at a steep discount to our fair value estimates. Even assuming a 10% drop in property prices over the next two years, their valuations still look attractive.
For investors seeking income, REITs may offer an attractive combination of yield and potential capital appreciation should market sentiment improve. Here are two of our analysts top picks from the industry pulse report.
Charter Hall Long WALE REIT (ASX:CLW)
- Fair Value Estimate: $4.60 (23% discount at 17 August)
- Rating: ★★★★
- Moat: None
We believe the market underappreciates a resilient property portfolio like Charter Hall Long WALE’s as it currently trades materially below the underlying asset values. Its property portfolio is diversified across retail, industrial, office, and social infrastructure sectors.
The REIT’s income is relatively secure and stable, underpinned by long leases to solid tenants. Half the leases are inflation-linked, and half are “triple net,” where tenants bear most property costs, including maintenance capital expenditure.
Following its recent earnings update, we maintain our fair value estimate of $4.60 per share for no-moat Charter Hall Long WALE, as there are no material changes to our long-term forecasts. Securities are attractive, offering an unfranked yield of 7%. Its net tangible assets improved slightly to $4.71 per security, driven by solid rent growth and flat capitalization rates.
Mirvac Group (ASX:MGR)
- Fair Value Estimate: $2.50 (30% discount at 17 August)
- Rating: ★★★★★
- Moat: None
Mirvac stands to benefit from Australia’s strong population growth and housing shortage. Residential development margins are likely to remain at the bottom end of the midcycle range of 18%-22% in the near term due to elevated construction costs and interest rates.
But they should recover, as Mirvac works through subcontractor defaults. Three rate rises this year and recent tax reform have pushed property prices down. However, we think Mirvac’s offerings should remain attractive, given its reputation for quality and the fact that new builds are carved out from the tax changes.
Most property values are likely to decline further in the wake of persistently elevated interest rates, but this is offset by the intangible value of Mirvac’s development and funds management businesses.
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