“Property price slump slows from record speed” and “Sydney’s property market is in a historic annual price fall.” These are two of many headlines plucked from major news publications in Australia to start 2023.
A similar headline could have been used in 2022 for listed real estate investment trusts (REITs), despite the fact that these headlines relate to the residential property market. As the S&P/ASX 200 A-REIT Index declined -21.46 % in 2022, investors might wonder if the decline will continue in 2023.
REITs: what are they?
Real estate investment trusts, or REITs, are companies that own, operate, or finance income-generating properties. As a result of REITs, investors are able to gain exposure to real estate assets without having to own them directly.
Australian REITs have experienced rapid growth in recent years, with several new listings and a growing number of investment options available. Low interest rates, a stable economy, and investor demand for income-generating investments have all contributed to this growth.
If you need more information on REITs, contact your local financial planning Newcastle services (or wherever your local town might be).
REITs have many advantages
The ability of REITs to provide regular and stable income is one of their key advantages. REITs must pay out at least 90% of their taxable income in dividends to shareholders to avoid taxation at the trust level. A low-interest rate environment makes REITs an attractive option for investors seeking a reliable income stream.
The key to the preceding sentence is “in a low-rate environment.” So, how attractive are REITs now that interest rates are rising? Investors would most likely say that if interest rates continue to rise, property investment becomes less attractive, because that is the million-dollar question. Although this may be true for residential property investment, there are a few key factors that could offset this.
History of REIT performance
Real estate investors can expect another tough year as interest rates in Australia are forecast to rise by 50 to 100 basis points. A historical analysis indicates that Australian listed REITs have returned on average 7% p.a. during the last 7 RBA tightening cycles (interest rates increasing).
It is important to understand why the RBA increases the cash rate in order to decode the above data. Inflation is pushed higher by low unemployment rates, wage growth and increasing consumer spending. As rents are mostly correlated with the Consumer Price Index (CPI), revenues will rise during the cycle and remain at these elevated levels once interest rates stabilize. When combined with declining gearing rates, 27.5% on average compared to 46% 15 years ago, REITs are set to benefit once interest rates peak.
To take this one step further, Experts have overlaid 30 years of RBA cash rate data with a 30-year performance chart for the S&P/ASX 200 A-REIT Index (XPK). A-REIT returns would be assumed to be negatively correlated with changes in cash rates, but the chart below shows that interest rates aren’t always the driving force behind real estate returns.
There is a positive correlation between the two data points in the chart above, specifically during the period 2001-2009. After the dot-com crash scare away a generation of investors from internet stocks, investors were looking for safer investments rather than buying into REITs due to the cash rate at this time. Your local financial planning Newcastle services can assist.
The future of REITs
Several people are concerned this year that property valuations will be lowered. As interest rates rise, capitalisation rates (cap rates) on property rise. A cap rate is used in the property sector to value the expected future cash flows. A higher cap rate reduces a property’s value because investors expect a greater return on their investment.
Government bonds now provide investors with higher risk-free returns because interest rates have increased. Therefore, investors expect REITs (and other investments) to yield higher returns because they are taking on greater risk. Property valuations may fall as a result, increasing yields. It is expected that cap rates across the REIT index will increase in 2023, but some sectors will be more affected.
Consequently, office REITs may see a decline in valuations as hybrid working takes hold due to subdued leasing activity. Alternatively, REITs specializing in healthcare and non-discretionary retail will have relatively stable cap rates since landlords can increase rent in line with CPI. In the Oracle Property Securities Portfolio, we recently decreased our weightings towards the aforementioned and increased our weightings to the latter mentioned.
In summary
In addition to the quality of the underlying properties, the management team, and the company’s financial health, it is essential to consider several factors when investing in REITs. In addition to dividend yields and capital growth potential, investors should also consider overall risk profiles. A better year is expected for REITs given a -20% decline in the index in 2022.
And, if you have any questions at all, don’t forget to contact your local financial planning Newcastle services (or whatever town or city is local to you).
Related Blog: Is it a Good Idea to Invest in REITs?
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