The listed Australian property sector (AREITs) has had a very strong 12 months, returning 19.3% (including dividends) vs. the ASX 200’s return of 11.5%[1]. This is quite a spectacular return for what is often considered a low volatility, slow moving asset class.
Source: Iress
So, what’s driven this strong return? Ultimately, falling bond yields. With lower growth and lower inflationary expectations globally you’ve seen bonds rally in price and as a result the yields they offer continue to decline.
Sources: Iress
In June, the Reserve Bank of Australia cut the official cash rate by 0.25% to a record low 1.25%, and as you can see below, the market has assigned a 75% probability of another 0.25% rate cut on the 2nd of July. Post the writing of this blog, the RBA cut the OCR to 1% on the 2nd of July.
Source: Bloomberg
What does this mean for REITs?
What you now have is a sector with a very low cost of equity and a very low cost of debt, particularly relative to its recent history. A very simple way of understanding the cost of equity, is to think about an equity raising as an example. Should a company wish to raise $100m, with a share price of $10, they’d need to issue 10m additional new shares. This would then mean the company’s earnings are spread across an additional 10m shares. Well if you had a share price of $20, you’d only have to add 5m new shares to achieve the same capital raise result, meaning the cost of raising the equity is lower.
And what have we seen thus far? According to JP Morgan research, we’re experiencing the highest level of capital raisings (and buybacks) since 2010. In the graph below these capital raisings have accelerated as the year has gone on.
Source: Milford research and Iress
We estimate about A$4,972m of equity has been raised by the property sector in FY19 (1/7/18 – 30/6/2019) which is very significant particularly considering $3.4b of this $5b was raised in May and June of this year. This does have to be put into context as a considerable amount of equity “left” the share market, due to capital activity. From the start of 2018 we estimate about $24b of equity has been delisted and/or acquired, with only $3.5b being listed. The most significant contributor to this outflow is Westfield, which was acquired by Unibail (now URW) in 2018 and stopped trading officially on the 8th of June 2018 (to simplify this we class Westfield as a de-listing, and Unibail as a listing).
Therefore, if we look at the total supply for the AREIT market since June of 2018, we are still in a net deficit of ~$15b despite these capital raisings. There are a couple things that require further consideration such as how much of the Westfield register was based offshore, how many Australians own the European version of Unibail however it gives you a rough indication of how the supply of this sector has changed.
Finally, what has the performance been like of those that have raised capital? It is not unusual for a company that raises a significant amount of capital to perform poorly post this as the market ingests the sudden increase in supply. However, given the trajectory of bond yields and assuming you’d purchased a share at each raise price, 17 of the 18 posted a positive return 1 month following the capital raise. The average 1-month return was 4.1% which is a very attractive return.
Source: Milford research and Iress
Where to from here?
With bond yields declining and low costs of equity and debt, we’d expect activity in this sector to remain elevated as companies deploy this capital into physical assets. This could see capitalisation rates tighten (essentially Net Operating Income divided by the assets value) and the valuation of property rise, further increasing the borrowing capacity of these companies as the value of their assets have increased, and hence their loan to value ratio would have declined. This could then lead to further capital activity and hence, higher valuations.
This is not linear and there are risks to these businesses just like any other with some sectors within property better suited to this environment than others – for example if you’d acquired Scentre Group a year ago rather than Goodman Group you would have received a total return of -7.48%, vs +59%. This highlights the value of stock selection and we believe this is more important than ever within the property sector given the strong run it has had.