Stuart Cartledge

Market commentary

The S&P/ASX 300 A-REIT Accumulation Index moved marginally higher in the first quarter of the year – rising 0.3%. This performance can be seen as relatively muted, considering the 10-year Australian Government bond yield dropped 0.5% over the quarter. The broader equity market outperformed property, with the S&P/ASX 300 Accumulation Index adding 3.3%. In February, most companies under coverage reported their half yearly earnings to 31 December 2022.

Valuations were broadly flat across the sector, although the tone was more cautious looking forward. A feature of discussions surrounded the impact of rising interest rates on future earnings and property valuations. Interest rate relief towards the end of the quarter should support earnings and limit downward revisions to valuations.

REITs with exposure to office markets were underperformers in the first quarter of the year. Amongst an environment of concern over the future use of office spaces, vacancy and incentives in key markets have remained stubbornly elevated, leading some to have concerns surrounding the sustainability of cash flows coming from office building ownership.

Many listed office owners argue that there will be a bifurcation, by which higher quality offices will endure and lower quality buildings will face a challenging future. Time will tell if this is correct. For the quarter, Cromwell Property Group (CMW) lost 15.1%, while Mirvac Group (MGR) dropped 2.3% and Dexus was off 3.1%. Charter Hall Group’s (CHC) earnings are particularly leveraged to office markets, given its franchise in office funds management. Its share price fell 8.2% during the quarter.

The drop in bond yields and short-term interest rate expectations were supportive of residential property developers during the period. Stockland (SGP) is the largest residential land developer in the country and as such rose 9.6% during the quarter. SGP’s management had previously suggested they would slow down land accumulation in a weakening market. At its half yearly report, the tone changed, with a goal to add to its land bank, supported by a new joint venture with Japanese real estate developer Mitsubishi Estates.

Smaller capitalisation residential developers AV Jennings Limited (AVJ) and Peet Limited (PPC) also outperformed, gaining 4.0% and 3.1% respectively. Owners of large shopping centres reported resilient financial results to 31 December, with specialty sales and rental outcomes broadly above expectations. Vicinity Centres (VCX) upgraded its full year earnings guidance, supported by almost flat re-leasing spreads, improving from -6.8% at the same time a year ago. VCX finished the quarter up 0.1%. Scentre Group (SCG) released earnings guidance for calendar year 2023, which was higher than expectations. It finished the quarter down 1.6% with some fearing a weaker economy moving forward.

Offshore, Unibail-Rodamco-Westfield (URW) outperformed on the back of results that are best summarised as less bad than expected. For the quarter it rose 3.6%. Industrial property owners faced a mixed period. In terms of property valuations, capitalisation rates increased sharply, however valuations were mostly slightly higher, supported by an acceleration in market rents around the nation’s industrial leasing markets. Industrial fund manager Goodman Group (GMG) led the way, adding 8.2%, while Growthpoint Properties Australia (GOZ) lifted 2.0% and Centuria Industrial REIT (CIP) gave up 2.6%.

Market Outlook

February’s reporting season showed a property sector that was mostly performing solidly from an operational perspective. Increased interest rates are however unmistakably a drag to earnings, given the use of debt across real estate investment trusts. Current gearing levels are however very manageable. Property valuations to 31 December 2022 mostly showed slightly negative revaluations.

The industrial sub-sector continues to be the most sought after, given the tailwinds of e-commerce growth, the potential onshoring of key manufacturing categories and the decision by many corporates to build some redundancy into supply chains to cope with current disruptions. All of these factors will support ongoing demand for industrial space, which is evident by rapidly accelerating market rents for properties.

The jury is still out on exactly how tenants will use office space moving forward, but demand for good quality well located space remains. Transactional activity of office assets continues to provide some evidence of value, but transaction volumes have recently reduced. Incentives on new leases do remain elevated and some vacancy in the market is becoming apparent.

We remain cognisant of the structural changes occurring in the retail sector with the growing penetration of online sales and the greater importance of experiential offering inside malls. Recent performance of shopping centre owners has however been strong, with consumers showing resilience. It is interesting to note the juxtaposition of very high retail sales figures despite very low levels of consumer confidence, no doubt impacted by rising costs of living.

The recent increase in bond yields does present a headwind for all financial assets, and particularly yield based sectors such as property. However, with key large capitalisation REITs now trading at a significant discount to the value of their underlying assets and with no value ascribed to embedded active businesses, we believe the sector offers value, particularly in comparison to unlisted property.

Phoenix has for some time discussed the risk of inflation, given the enormous fiscal stimulus and extreme monetary policy setting that we have lived through. In recent times, commentators and bond markets have begun to react to the presence of such a risk. In this environment, long leases with fixed rent bumps, which were previously in high demand, may become relatively less attractive. Historically, real assets such as property and infrastructure have performed well during inflationary periods.

Why changing occupier demand means investment opportunity

Hybrid working, where white-collar employees divide their working week between home and the office, is now the default for Australian companies. This trend was in motion prior to the pandemic, but has been accelerated and solidified by it, establishing it as the norm.

With employees in the office fewer days per week, the role of the office has changed. In parallel, other structural themes are shifting occupier expectations about their offices faster than the market can adapt. These themes include the environment and the need for offices to help mitigate the climate crisis; demographics with a new group of gen-Z employees born since 1997 coming of age; and technology changing the type of work that is done and where it is undertaken (Figure 1). For informed investors who act with conviction, filling the supply gap by providing office space suitable for modern occupation brings performance opportunity.

Figure 1: The themes behind new office requirements

Stuart Cartledge

The S&P/ASX 300 A-REIT Accumulation Index reversed some of 2022’s losses in the final quarter of the calendar year, gaining 11.6%. Results were choppy throughout the period, with a gain of 9.9% in October, followed by a 5.8% move higher in November, before a 4.0% drop in December. The property index outperformed the broader equity market, with the S&P/ASX 300 Accumulation Index up 9.1%.

Much like property market movements, Australian 10 Year Government Bond yields were volatile throughout the quarter. After beginning the quarter at 3.9%, they retreated to approximately 3.3% before finishing the quarter just above where they started at 4.0%. In this context, the strong performance of property stocks could be considered somewhat surprising, however this is probably less remarkable when considered more broadly, with the property index falling 20.1% during 2022. Industrial property owners outperformed in the December quarter.

Demand from tenants for industrial property continues to be strong, with limited vacancy in key markets. Whilst supply is coming online, it is not enough to match demand for well-located properties. As such, industrial market rental growth is very strong, supporting property values, despite expanding capitalisation rates. Dexus Industria REIT (DXI) rose 24.1% in the quarter and Centuria Industrial REIT (CIP) added 22.0%. CIP’s revaluations resulted in a 1.9% reduction to book values, concentrated in ultra-long weighted average lease expiry (WALE) properties. Capitalisation rates expanded 0.47% to 4.66%.

DXI’s portfolio was revalued 0.2% higher, despite capitalisation rates expanding by 0.09%. Owners of shopping centres also outperformed in the quarter, as consumer spending through the crucial holiday season appears to have been resilient, despite the drag of increased interest rates. Whether this continues into 2023 and beyond, as increased costs of living filter through and deplete savings, is uncertain. Offshore shopping centre owner Unibail-Rodamco-Westfield (URW) was a major outperformer, rising 26.1%, however this only served to regain a part of prior losses in recent periods. Australian shopping mall owners Scentre Group (SCG) and Vicinity Centres (VCX) were also outperformers, adding 13.4% and 15.3% respectively.

Owners of smaller neighbourhood shopping centres had mixed performance, with Region Group (RGN) up 18.5% and Charter Hall Retail REIT (CQR) underperforming the index, but still gaining 7.6%. Office property owners were once again underperformers in the final quarter of 2022. Physical occupancy continues to be troubled in key office markets and incentives on new leasing deals continue to be stubbornly high.

Each of Centuria Office REIT (COF), Dexus (DXS) and Cromwell Property Group (CMW) rose, but underperformed the index, lifting 7.6%, 4.0% and 2.1% respectively. GDI Property Group, predominantly a Perth office owner, was a large underperformer, falling 8.1% during the quarter. Property fund managers had mixed performance over the period. Property revaluations were broadly unmoved, supporting earnings for this financial year, however it appears as if inflows to funds will be more constrained moving forward.

Centuria Capital Group (CNI) outperformed, adding 14.6%, whilst Goodman Group (GMG) moved roughly in line with the index, up 11.0%. Alternatively, Charter Hall Group (CHC) and Elanor Investors Group (ENN) underperformed, with CHC gaining 6.2% and ENN up only 0.8%.

Market outlook

August’s reporting season was broadly positive for property stocks when looking into the recent past. However, forward looking outlook statements were cautious, with a focus on the impacts of higher interest rates. Those who released property valuations to 31 December 2022 mostly showed slightly negative revaluations with some reporting rental growth offsetting capitalisation rate expansion.

The industrial sub-sector continues to be the most sought after, given the tailwinds of e-commerce growth, the potential onshoring of key manufacturing categories and the decision by many corporates to build some redundancy into supply chains to cope with current disruptions. All of these factors will support ongoing demand for industrial space.

The jury is still out on exactly how tenants will use office space moving forward, but demand for good quality well located space remains. Transactional activity of office assets continues to provide some evidence of value, but transaction volumes have recently reduced.

We remain cognisant of the structural changes occurring in the retail sector with the growing penetration of online sales and the greater importance of experiential offering inside malls. Recent events will likely accelerate these changes. It is also interesting to note the juxtaposition of very high retail sales figures despite very low levels of consumer confidence, no doubt impacted by rising costs of living.

The recent increase in bond yields does present a headwind for all financial assets, and particularly yield based sectors such as property. However, with key large capitalisation REITs now trading at a significant discount to the value of their underlying assets and with no value ascribed to embedded active businesses, we believe the sector offers value, particularly in comparison to unlisted property.

Phoenix Portfolios has for some time discussed the risk of inflation, given the enormous fiscal stimulus and extreme monetary policy setting that we have lived through. In recent times, commentators and bond markets have begun to react to the presence of such a risk. In this environment, long leases with fixed rent bumps, which were previously in high demand, may become relatively less attractive. Historically, real assets such as property and infrastructure have performed well during inflationary periods.