The A-REIT sector had a torrid March as the COVID-19 virus hit Australian shores. Local investors are now familiar with both the devastating health consequences of the virus as well the unprecedented social distancing measures that governments have been forced to implement to curb its spread.
These measures have hit the A-REIT sector hard, with retail assets being particularly impacted by the mandated closure of non-essential businesses, and the decision by some large national retail groups to temporarily reduce their bricks and mortar footprints. However, as the economic fall-out from C-19 grows wider, the other key sectors – office and industrial – will increasingly feel the impacts of falling business confidence and GDP.
There is a silver lining for investors, though. A-REITs have entered the C-19 market with a more defensive financial profile due to the GFC learnings. Hence, while the C-19 impacts will squeeze liquidity, raising the risks of capital raisings and distribution deferrals, investors should avoid the insolvencies or deeply dilutive rights issues that plagued the sector in 2008-2009.
The scale of the A-REIT sell-off can best be ascertained by a review of the 31 March 2020 performance data for its headline index, the S&P/ASX 200 A-REIT Index (XPJ). The XPJ provided investors with an abysmal -35.2% total return for the month of March – a negative monthly return which even eclipsed the worst of the GFC period. This calamitous result has also skewed the longer-term track record for investors, with the three- and five-year total returns now also falling into negative territory (-6.4% p.a. and -1.2% p.a. respectively).
This was despite the A-REIT sector having performed strongly in the calendar year 2019 due both to the bottom-up success of the Goodman Group in rolling out its specialist logistics business plans, and strong asset performance for the office and industrial sectors. After such a large price move, S&P noted in its March index update that the sector was trading at 0.56x book value and an indicative forward yield of 6.8%, which at face value would appear an attractive valuation entry point. But first we need to better understand why the index was sold off so heavily.
Where the retail sector goes, so goes the index
The A-REIT sector is highly concentrated, with a handful of names accounting for the majority of the market cap. For example, we have provided some analysis on the current price action for individual REITs with a market cap above $3 billion (see table below). This group of eight REITs currently accounts for approximately 80% of the XPJ’s market cap. What this also means is that some bottom-up issues for a large REIT or sector can have a similarly large impact on the index.
When comparing the drawdown of these REITs from mid-February to their March lows, we can see that this sector was the retail-only REITs such as Scentre Group and Vicinity Centres, which had significantly worse drawdowns of 62 to 64%. Further, while Scentre, for instance, has clawed back some of the drawdown, it is still much further off its mid-February peak compared to the broader sector. Given this, a greater understanding of the dynamics at play in the retail sector will go a long way to gaining a better understanding the current A-REIT dynamics.
Large-cap A-REITs have suffered large drawdowns since COVID-19 hit
|ASX Code||Name||Last 15’Apr||Mkt Cap $’b||% of Index||Sector||Mid’Feb Price||Mar’20 Low||Draw down||Recovery||% off Feb|
Source: Lonsec, IRESS
Retail REITs globally have been facing long-term structural headwinds due to strong competition being placed on certain segments, such as apparel and department stores, by the advent of online shopping. Retail REITs have been seeking to negate this challenge by changing their leasing mix to more ‘experienced-based’ tenancies offering services such as dining, cinemas, gymnasiums and healthcare.
If consumers are going online to shop for some of these disrupted categories, then landlords need to pull the services lever to restore foot traffic. Scentre is a good example of this dynamic, having been particularly successful in executing this strategy with 43% of the stores across its platform categorised as ‘experience-based’ at the end of 2019. The combined impact of a softer department store and specialty rental sector, along with the additional leasing and fit out costs of the forced conversion, has also impacted the operating cash performance and balance sheet metrics of the retail REIT sector versus office and industrial. This saw retail specialist REITs enter 2020 with reduced liquidity and more stretched balance sheets.
Unfortunately for retail REITs, a tenancy portfolio heavily weighted towards ‘experience-based’ tenancies rapidly morphed into a portfolio full of ‘non-essential’ services in the C-19 pandemic. Forced closures have also occurred at the same time as foot traffic has declined due to both isolation directives for the general public and the drop-off in international travel, which in turn has led retailers with large national ‘bricks and mortar’ store networks temporarily closing their shops.
The end result has been a perfect storm for retail REITs faced with the prospect of a large decline in Funds form Operations (FFO) due to reduced variable rents, rent relief support for impacted tenants, and ultimately increased spreads on lease renegotiations and higher vacancies.
A-REIT balance sheets are holding up in face of the COVID-19 crisis
Despite the headwinds of C-19, balance sheet conservatism means it is still unlikely that larger trusts will need to resort to the deeply dilutive recapitalisations witnessed during the GFC. As the table below shows, balance sheet metrics for the top five A-REITs by market cap as at 31 December 2019 indicate that debt remains manageable. Outside of Scentre Group, the other large REITs all have conservative metrics, with gearing ratios well below 30% and Interest Coverage Ratios (ICRs) above 5x. Further, the composition of their loan books are demarcated by a much greater exposure to bond markets, longer-dated terms to maturity, and ample liquidity.
Balance sheet metrics for top five large A-REITs remain relatively healthy
|ASX Code||Name||Gearing ratio||ICR (x)||Liquid. $’b||Bonds||Term Mat. (Yrs)||Current Refis $’b||Int. Costs|
Source: Lonsec, Company Financial Reports
The outlier here, however, is Scentre Group, with the longer-term retail sector headwinds meaning it entered the C-19 period with both a higher gearing ratio of 33%, a lower ICR of 3.6x, and the need to refinance over $2.5 billion in debt expiring in the short term. This, along with the more acute impacts on its operations from C-19, is a key reason for its recent underperformance versus peers. However, even Scentre’s metrics are well below the GFC, when the average gearing ratio was closer to 40% and the ethos of financing long-term assets with short-term bank debt was in the ascendancy.
There is still a great deal of uncertainty and many moving parts to the C-19 pandemic, including government policy responses, and likely many months before the economy returns to normal (or as close to normal as we can expect). Overall, however, the major A-REITs appear in good shape and are well positioned to weather the storm without the scale of the recapitalisations we saw in 2008-09.
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