Real estate investment trusts ready to go after tough season

Australia’s top property companies are coming through the worst of valuation write-downs and are now finding a way forward.

Real estate investment trusts have come through a tough reporting season and are positioned to turn the corner.

Real estate investment trusts have come through a tough reporting season and are positioned to turn the corner as the weight of high debt costs and falling property values are expected to ease by the middle of the year.

While there are still few major transactions and the global environment is uncertain, top property companies flagged that they are coming through the worst of valuation write-downs and have provided positive earnings guidance.

This would see them come through the worst slump in commercial property activity in more than a decade and ready to take on the challenge of new sectors ranging from build-to-rent, data centres, healthcare property, self-storage and student accommodation.

The optimistic case for the real estate investment trust sector is starting to gain traction after a reporting season marked out by better than expected performances from big shopping centre owners and office owners, adjusting portfolios to tougher times.

But a harbinger of the future will be the supercharged outlook from industrial property heavyweight the Goodman Group as it charges further into data centres.

While traditional office funds were under pressure due to high vacancy levels and unattractive structural challenges, even here dramatic falls in values are expected to bottom out in the middle of this year.

An artists impression of a proposed Goodman Group data centre development in Sydney.

And right across the sector, the stabilisation of interest rates – for now – has also prompted a more upbeat outlook for property funds managers, even though they remain under pressure from institutions to boost the performance of their satellite funds.

These relatively positive outlook given by big listed companies in the reporting season is also likely to help drive the property market in a more positive direction.

In a reporting season marked by few disappointments, most companies showed that they were well positioned to survive the worst of any crisis after coming through the pandemic.

JPMorgan analyst Richard Jones said that standouts from REIT reporting season included the Goodman Group delivering 28 per cent earnings per security growth and being included in a major global index, and advancing its data centre pipeline.

He also called out retail malls generating record releasing spreads, which accelerated in the last half, with rising occupancy in centres and more resilient than expected retail sales growth.

But he said that the rising cost of debt had wiped out two years of sector earnings growth – barring Goodman Group – but said that added the bulk of the headwind from that force should be captured in current guidance.

Goodman Group is looking to build up a new empire based on AI, creating a surge in demand for data centres.

“We’re leveraging our competitive advantage by securing power, planning and commencing infrastructure works,” chief executive Greg Goodman said.

16/2/22: Greg Goodman, Head of Goodman Group ahead of the release of the company's results. John Feder/The Australian.

Other big companies are also bullish that transactions will come out of their current doldrums.

Charter Hall said that market sentiment and activity indicate that interest rates are peaking, and the devaluation cycle was largely behind the market, notwithstanding conditions remaining volatile and secondary asset values being under pressure.

“I think the coming period is going to be one where we need to take advantage of opportunities,” Charter Hall managing director David Harrison told investors.

“I think we’ve done a pretty good job over the last 20 years of avoiding some sectors that have had some real challenges and being prepared to sort of participate in the institutionalisation of new sectors.”

JPMorgan’s Mr Jones said that transaction markets had likely bottomed, as investment demand was improving, albeit he expected a recovery to be gradual, with valuations about 18 months into a 24-month correction.

JPMorgan forecast fiscal 2024 earnings per security growth of about 3 per cent for the REIT sector, or pretty flat once Goodman is excluded, as rising debt costs erodes sector growth.

Mr Jones expected that growth would be back to more normalised levels from next financial year. The broker’s preferred big property stocks are Scentre, GPT Group, Dexus and Charter Hall Group.

Mr Jones said that in the surprisingly strong mall sector there were record releasing spreads, rising occupancy and resilient sales. Offices, by contrast, had modest occupancy declines, with valuations are down 5.4 per cent and leasing demand having likely bottomed.

In malls, very strong metrics were reported by GPT, Scentre and Vicinity in particular.

Releasing spreads surprisingly accelerated in the second half, occupancy rose and was tipped to head higher in 2024, on the back of resilient retail sales.

“This supports our view that mall rents remain at very sustainable levels for tenants, and that leasing spreads can remain positive throughout the balance of 2024,” he said.

L to R, Pia Murphy & Ruby Cannon, for extended shopping on Thursday, Westfield Shopping Centre Chermside, on Tuesday 19th December 2023 - Photo Steve Pohlner

JPMorgan said that one key drag on the sector – debt costs – would be largely done in this financial year. The key impediment to growth this year is the rising average cost of debt but, from next financial year, only minor increases in debt costs were expected.

Jarden analyst Lou Pirenc said that the sector broadly made progress on improving balance sheet pressure, secure hedging for the next 18 months and focus on cost control.

With interest rates getting close to cycle peaks, he argued there were signs that the sector was trying to move from playing defence to playing offence, and expects earnings momentum to improve from here. But some trusts were still dealing with ongoing balance sheet and debt headwinds.

Mr Pirenc said that the December results were broadly in line with expectations and while the cash coverage of Funds From Operations – a key earnings measure – deteriorated, partly due to a skew to this half among developers.

Despite an overall positive take, he noted concerns about the deteriorating cash flow profiles of some of the REITs as not being properly reflected in asset valuations, which may eventually put more pressure on asset classes where cash flows are under scrutiny.

In a nod to the emergence of new sectors, Jarden sees the strongest growth momentum in the manufactured housing and land lease asset class, while it says the growth for the asset fund managers is mixed, albeit harder to forecast given the uncertainty about deals.

It also expects the momentum to improve for residential developers, saying that Stockland is better positioned than Mirvac after the former bought the bulk of Lendlease’s housing estates operation.

For more passive trusts, it sees the strongest growth momentum in the newer sectors of storage and childcare but cautioned that REITs, with higher gearing and a cheap base cost of debt, may be hit by rising interest expenses.

Jefferies analyst Sholto Maconochie said that results from property trusts were slightly above expectations, calling out Goodman Group and Centuria Industrial REIT for upgrading their earnings forecasts when delivering their results. In stark contrast, developer Lendlease warned on its earnings.

In a nod to an expected run of deals later this year, he said non-core asset sales and capital partnering remain a core strategy for A-REITs that have elevated gearing, or big development pipelines to fund.

But for now there was a greater focus on development over acquisitions – with Region Group, Centuria Industrial, Mirvac and Stockland busy on this front – as acquisitions don’t stack up.

Mr Maconochie said that construction costs remained elevated but appeared to have peaked, or at least stabilised. Notably, some companies have also pushed back their development pipelines, or even cancelled projects. Some mixed use projects are also off the table due to higher building costs or weaker tenant demand.

He said there had been a pick-up in residential demand in this quarter, but affordability for first home buyers was still a concern.

On a cautious note, Mr Maconochie also called out higher office vacancy, which is hitting stocks like such as Dexus and Centuria Office REIT. He noted that leasing volumes were slightly better than expected, but deals were being done at higher incentives, which are expected to persist, resulting in increased leasing capital spending.

Mr Maconochie said asset values were still under pressure, with cap rates increasing and valuations likely to trough in June. But this half could be a big one for listed property as the tough times start to fade away.

Originally published as Real estate investment trusts ready to go after tough season