Key points
- A-REITs collectively met market expectations during the latest profit-reporting season, unlike industrial stocks, which disappointed, particularly on their earnings guidance for 2015-16.
- The Asia Pacific Data Centre Group (AJD) A-REIT owns data centres and is a lower-risk play on the cloud-computing boom, while National Storage REIT is benefiting from opportunities in the highly fragmented self-storage industry.
- The Arena A-REIT invests in the growth sectors of healthcare, childcare and education and has exposure to government-tenanted facilities, while the US Masters Residential Property Fund A-REIT invests in undervalued neighbourhoods in growth markets that are within an hour’s commute of downtown Manhattan.
A 9% correction in the Australian Real Estate Investment Trusts (A-REIT) sector since March has put it back on the radar for long-term income investors. Smaller, specialist A-REITs, in particular, look interesting after heavy price falls.
A pullback was needed. The search for yield sparked a stunning rally in A-REITs last year and early this year, and drove many above their asset backing. The sector was overvalued but the weight of money and expectations of rising property prices fuelled gains. Let’s have a closer examination of the sector before considering five smaller A-REITs that could add value.
The sector overview
The S&P/ASX 200 A-REIT index soared 33% between January 2014 and February 2015, underpinned by gains in sector heavyweights Westfield Corporation and Goodman Group. The sector easily outperformed the broader Australian share market, even after accounting for the A-REIT index’s falls this year.
S&P/ASX 200 A-REIT index
[1]On a total-return basis, the S&P/ASX 200 A-REIT index has a one-year return (including distributions) of 16%. The S&P/ASX 200 index has 3% negative return, after heavy falls in the past few months. Over five years, the A-REIT index has returned 13% annually, versus 6% for the S&P/ASX 200.
Several factors underpinned the rally. Record-low interest rates and measly cash rates forced more investors to buy bank, utility and property stocks for yield. Also, underlying property prices kept rising, despite sluggish economic activity. And the A-REIT sector was in better financial health after its debt and management excesses in the lead-up to the 2008 GFC.
A-REITs collectively met market expectations during the latest profit-reporting season, unlike industrial stocks, which disappointed, particularly on their earnings guidance for 2015-16. Earnings and dividends forecasts for the A-REIT sector have been downgraded, but not by as much as industrial companies, consensus analyst forecasts show.
Much depends on interest rates. An expected rise in US interest rates over the next 18 months is a headwind for interest-rate-sensitive stocks, such as A-REITs. The sector historically outperforms the share market when bond yields fall and underperforms when they rise.
But the US Federal Reserve seems in no hurry to raise rates, after keeping them on hold this month because of the unstable global economic outlook.
Moreover, A-REITs typically outperform in periods of high share market volatility because income from long-term leases is, in theory, more certain than corporate profits. Expected distribution yields of 5-6% in FY16 for many of the largest A-REITs are another positive.
There is enough to suggest long-term investors should take advantage of lower prices to get set in the A-REIT sector again. But caution is needed: the prospect of US interest-rate rises, slowing earnings growth and an overvalued direct property market are threats.
Conservative investors should stick to the largest A-REITs that have a mix of assets. Westfield, GPT Group and Goodman Group appeal. Those with greater risk appetite should consider smaller, specialist A-REITs, some of which have listed in the past few years.
Australia is following US trends with specialist REITs emerging through the Initial Public Offering (IPO) market. The US market has REITs over prisons, student accommodation, residential property, public storage, mortgage providers, and many others.
Specialist A-REITs often grow by buying and consolidating smaller properties. They invest in a narrower property segment than large A-REITs, issue more equity to raise capital to acquire assets, and have higher tenant risks. Gains and losses can be larger.
Here are five specialist A-REITs to consider:
1. National Storage REIT (NSR)
After listing at 98 cents a unit in December 2013, the self-storage A-REIT peaked at $1.75, before easing to $1.49 yesterday. It is benefiting from opportunities in the highly fragmented self-storage industry. Longer term, it is a play on capital-city densification, smaller apartments and demand for extra storage space.
National Storage is not cheap. The $1.49 unit price compares with the latest stated net tangible asset (NTA) of $1.11 a unit – its premium to NTA is among the sector’s highest.
But it has a more attractive earnings growth profile than many A-REITs that is not fully captured in the NTA. It can grow faster than the sector by buying small self-storage operators, or operating their assets. It also has reasonable scope for occupancy growth.
National Storage’s FY16 guidance was slightly below market expectation. Still, it deserves a spot on portfolio watch lists in anticipation of improving value. It would look more interesting closer to $1.30.
National Storage REIT
[2]2. Asia Pacific Data Centre Group (AJD)
The NEXTDC spin-off owns data centres and is a lower-risk play on the cloud-computing boom. It will benefit as NEXTDC attracts more companies to its state-of-the-art data centres, in turn reducing tenancy risk for Asia Pacific Data Centre Group (AJD).
AJD rallied from $1.06 to a 52-week high of $1.32 and has since eased to $1.27. It arguably should trade at a higher premium to the latest stated NTA of $1.24 per unit, given AJD has excellent exposure to the fast-growing cloud-computing industry as more companies store and manage data offsite.
An expected yield of 7.5%, based on consensus forecasts, appeals. PM Capital, Bennelong Funds Management and a few other good judges are substantial shareholders.
Asia Pacific Data Centre Group
[3]3. Arena REIT
Investors could not get enough of Arena when it listed in June 2013 after raising $75 million at $1.01 a unit through an IPO. It peaked at $1.90 and now trades at $1.61.
Arena invests in the growth sectors of healthcare, childcare and education and has exposure to government-tenanted facilities. It delivered 19% growth in operating profit for FY15 and its net asset value increased 18% over the year.
Arena has relatively long leases, good geographic diversity, exposure to sectors with attractive fundamentals, and a healthy balance sheet. The $1.61 unit price compares with a NAV of $1.33, but Arena deserves a premium given its healthcare and childcare exposure.
Arena REIT
[4]4. Galileo Japan Trust
A smaller A-REIT, the Galileo Japan Trust, is also worth watching. Unlike many small-cap A-REITs, it trades at a significant discount to net asset value and offers exposure to the improving Japanese property market.
Its underlying FY15 earnings and FY16 guidance beat market expectation and it could yield as much as 10% given the expected increase in its distribution payout ratio.
At $1.77, Galileo trades at a 29% discount to its latest stated net asset value of $2.29 a unit. It is subject to currency risk from the Australian dollar/Japanese Yen, and as a micro-cap A-REIT it has higher debt and risk than others on this list. It does not suit conservative investors.
But I like the medium-term outlook for Japanese property and Galileo’s discount to NTA is excessive. Macquarie Equities has a 12-month price target of $1.96.
Galileo Japan Trust
[5]5. US Masters Residential Property Fund (URF)
URF was the first Australia-listed property trust established to invest directly in US residential property. It invests in undervalued neighbourhoods in growth markets that are within an hour’s commute of downtown Manhattan. The fund owned 543 properties at June 2015.
URF has rallied from $1.85 to $2.12 over 12 months, and performed strongly over three years. It trades at a modest premium to its latest stated net asset value (NAV) of $2.01 per unit (after accounting for estimated withholding tax if the portfolio was sold). The NAV is $2.20 a unit before withholding tax on unpaid distributions.
I like the outlook for US residential property as the country’s economy strengthens, and rate URF’s strategy to buy and renovate properties around New York. It completed 34 large-scale renovations and 62 small-scale renovations in the first half of FY15.
The fund is well run. It delivered 47% revenue growth in first-half FY15 over the prior corresponding period. URF said: “The fund anticipates rental revenue to continue to grow during the remainder of 2015 and in 2016 as more completed properties are delivered from the renovation pipeline.”
URF also expects further increases in the value of its property holdings, underpinned by its renovation work, rental income growth, and property sales in comparable markets.
The market is underestimating URF’s long-term potential, and it is easy to overlook. A fund that buys and renovates US residential properties is an unusual proposition compared with Australian REITs, which mostly invest in industrial, retail and commercial properties.
But US residential property is still recovering from losses after the 2008-09 GFC and the country’s housing cycle has further to run as interest rates remain low.
Moreover, URF’s strategy to buy and renovate US residential properties around New York provides a unique exposure for Australian investors via ASX. Investors who are “overweight” Australian residential property could consider the US variety for diversification.
US Masters Residential Property Fund
[6]Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at September 23, 2015.
All charts sourced at: Yahoo!7 Finance, 24 September 2015
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.