IMO aez is sooooo undervalued 2010 AREITs Outlook ? a measured dose of optimism and caution
After a tumultuous couple of years, the AREIT market looks set to continue along the road back to normality. Most industry observers agree that the last few years have been atypical for the sector, a traditionally defensive asset class which has acted anything but defensively throughout 2008/2009. The Global Financial Crisis (GFC) shook the nerves of some of the most experienced market participants and dealt a particularly brutal blow to the real estate sector.
We?ve since seen a steady rebound of the AREIT Index from its low point in March (546 points), by around 60% to 31 January 2010 which saw the AREIT Index close at 871 points. This has occurred in tandem with the re-financing of the AREIT sector as $17 billion of new equity was raised to repair and strengthen balance sheets throughout 2009. The direct real estate market has also significantly repriced and there is growing consensus that we are at or near the cyclical bottom.
The beginning of 2010 has seen the AREIT sector outperform the broader market by 3.3% in January. The general equities market experienced a rough start to the New Year, which fell 6.2% in January, the worst monthly performance since November 2008 amid concerns over the Chinese economy and the domestic profit-reporting season. We believe there are two key factors underpinning an improved sentiment in the ARIET sector ? the predominantly strong macroeconomic news (stronger than expected employment and retail sales); and stabilising asset valuations (several trusts reported only minimal declines in their portfolios for the December quarter).
The property sector?s outlook is certainly brighter that it was 12 months ago. The sector has confronted the unprecedented period of global financial market upheaval, recalibrated itself and is now on a more sustainable footing. Credit markets are also starting to normalise and many general economic indicators are beginning to reflect positive signals.
We examine the key drivers for the AREIT sector in 2010 as the world slowly emerges from the GFC. On balance, we see more positive than negative catalysts for 2010 and maintain a cautiously optimistic approach to the year ahead.
We?ve identified the following key drivers of the real estate sector as we enter the New Year:
?Low risk strategies should be rewarded ?Improvements in capital markets as debt becomes available and at cheaper margins ?Improvements in property fundamentals ?Improvements in the domestic economy Low risk strategies will be rewarded A move towards low risk investment strategies pervaded the property sector through 2009 which was a positive change for the industry. AREITs reduced gearing levels, repaired balance sheets, lowered distributions and reduced exposure to high risk earnings ? we expect to see these low risk strategies continue throughout 2010. Importantly, gearing levels should stabilise at around current levels of 30% (see chart below) which we believe is a sustainable level that supports greater earnings certainty.
We accept the trade off between lower risk and lower return and expect the low risk strategies of the various AREITs to be well supported over the year.
Groups which can access modest levels of risk controlled active earnings in residential development may be able to deliver higher than average earnings growth. In moderation, these earnings have a place in well managed portfolios. In particular, we see the supply constrained residential market providing upside to those groups that can match product to demand. We do not see these earnings reverting to pre GFC levels however.
Improvements in capital markets Capital markets are expected to continue to stabilise over 2010 as investor confidence returns. Pleasingly, AREIT debt costs have normalised after the bubble of the last few years. The chart below reflects debt market perceptions that the worst is over in this regard. It reflects the spreads for the publicly traded debt of some of the most prominent AREITs in the market.
We see current spreads stabilising at circa 200-300 basis points with the potential for further falls as capital markets become more comfortable with the AREIT market. This should also manifest itself in lower stock price volatility for AREITs over 2010. Simply, as investors perceive lower risk, they will be happy to pay higher prices for debt and equity investments.
Importantly, we are already seeing signs that the availability of debt is improving (particularly for the better quality, lower geared entities). Some domestic banks are not as constrained as they were 12 months ago and are signalling an ability to lend.
Improvements in property fundamentals In the face of dire economic conditions in recent times, we have seen a remarkably resiliant local commercial property market. Pleasingly, we?re seeing increasing evidence of real estate fundmentals holding firm, indicating the worst is past. Across all key property sectors (Office, Retail and Industrial), there is increasing evidence of rental growth, receding incentives, improving demand and positive net absorption.
Values appear to have stabilised reflecting the expectation from investors that the worst has past and the outlook is more positive. Indeed, the dearth of available investment stock has the potential to cause a modest increase in values over 2010 as some yields actually firm from potentially overly conservative valuations completed through 2009.
Negligible new construction in recent times means supply pressures do not exist. This is a key variable in the demand / supply equation indicating that 2010 should see real estate fundamentals continue to improve.
The following chart reflects the view that we are currently at the bottom of the cycle in regard to capital values for most markets (ie, yields are at or close to their peak in the office sector).
As property fundamentals continue to improve, we expect 2010 will also see an increase in sales transactions and development activity will be re-ignited which will also result in greater certainty surrounding values. Expect only the de-risked, better quality projects to garner support from debt providers ? this qualification will naturally keep a lid on overall supply levels.
*Source: JLL Preliminary Market Overview Q4 2009
Improvements in the domestic economy Over 2010 we expect to see domestic GDP progressively strengthen. Inflation should remain under control and interest rates will rise steadily in response to the RBA?s desire to normalise the interest rate setting. Even if unemployment rises, coming off a rate of 5.5% at the end of 2009 should not produce a major impact. Indeed, a rise in unemployment could be a factor to help stabilise the trajectory of interest rates which in the medium term would be positive for sentiment.
With business and consumer confidence remaining buoyant we do not expect to see a major reversal in economic fundamentals as domestic demand appears stable.
Monetary policy will take precedence over fiscal policy as stimulus spending is removed from the agenda and rate hikes take over the headlines.
Risks Whilst we maintain a cautiously optimistic outlook, we remain mindful of the risks. However, it?s hard to find serious risks to the AREIT sector in isolation. The following are broader economic risks that do not directly or immediately impact AREITs but rather, impact the sentiment across equity markets. In our view, the main impediments to a sustained recovery in global equity markets and economies are:
1. Regulation - In the shadow of the greatest market crisis in living memory it is possible that governments will be tempted to over regulate, which stifles markets. We are already seeing signs of this emerging in the US banking sector as the market grapples with political rhetoric on the topic.
2. China - If an orchestrated pull back in demand occurs in China, the repercussions could be significant. We are already seeing signs of policy actions designed to dampen speculation in selected residential markets. It?s also important to remember that the virtuous cycle of the buoyant West driving demand for goods out of China has slowed dramatically in recent times. With European and US recovery likely to be anaemic (as personal balance sheets are slowly repaired), demand for Chinese exports will likely stabilise at current reduced levels through 2010. This indicates overcapacity in Chinese industry that may be a drag on global growth in 2010.
3. Forced selling ? there is a chance we may see more aggressive management of defaulting loans by banks (i.e., forced asset sales).
In short Notwithstanding the above risks, we believe there are a number of upside potentials for the AREIT market which far outweigh the negatives. In short, these include:
?Stabilising capital values ?Stabilising rents and vacancy levels ?Improving macroeconomic factors (specifically unemployment and GDP) ?Opportunity for cashed-up trusts to make accretive acquisitions ?Greater ability to access debt ?Falling cost of debt ?Upwards earnings revisions from selected REITs We expect total returns from the AREIT sector to be in the range of 7-10% for the calendar year 2010. The total return will be predominantly derived from income. Whilst the AREIT yield has moderated relative to bonds (see graph below), the fact that this yield is substantially more sustainable (due to lower payout ratios, lower risk earnings and lower gearing) means that the quality of returns has actually improved in recent times. We see this trend continuing throughout 2010 which is a positive for the sector and sees a return to the traditional real estate investment model which focuses on income derived from the rent collected on commercial property; the conservative model that APN has always strongly supported.
As we embark upon a new year of opportunities and challenges, APN would like to wish our readers a prosperous 2010 and we look forward to arming you with valuable insights into the real estate sector to help keep you abreast of the real estate sector over the ensuing year.
AEZ Price at posting:
5.0¢ Sentiment: Buy Disclosure: Held
