Company news

Yield and volatility - a compelling relative value in the AREIT sector

After the sharp decline of the AREIT sector throughout the Global Financial Crisis (GFC), the recent rebound in the AREIT market is attracting plenty of attention. The 53% total return from the sector since the market trough in March 2009 (to 31 May 2010) has been spectacular. In this month’s Hot Topic we explore the stabilisation of the AREIT market and its volatility in relation to other sectors/asset classes that also focus on income.

Pleasingly, in the aftermath of the GFC, AREITs are returning to the passive rent collecting vehicles they were always intended to be. In the eye of the perfect storm that was the GFC, AREITs strayed from the traditionally defensive property ownership model as they acquired an overly zealous appetite for debt, corporate style and offshore earnings in an attempt to chase equity like earnings. The sector has since transformed itself - the recapitalisation of the sector, reopening of credit markets, revision of AREIT strategies (return to a lower risk model with a domestic focus) and stabilisation of commercial property markets have all contributed to the strong rebound in the AREIT market.

AREIT yield is compelling

Consistent with the market rally, the AREIT sector yield has reduced to 6.0% which reflects the average yield of the S&P/ASX 200 A-REIT Index (Index). However, it’s important to note that the sector yield is driven down by Westfield which comprises 41.6% of the Index. The yield of Westfield in 2011 will be approximately 5.2% (66 cents distribution is the consensus forecast; and current price of Westfield is $12.74 as at 31 May 2010). If Westfield is excluded from the Index, the AREIT market yields 6.5%.

As an active portfolio manager however, we do not hold stocks according to index weights in our portfolios and apply a rigorous investment process in order to determine which stocks present the most compelling value at the current prices. The aim is to generate relatively high risk-adjusted income across our portfolios. The benefits of an active investment approach are evident in the current yields of our APN securities funds.

Active style management can also generate additional distributable earnings. With modest turnover we can realise additional profits for our investors. The AREIT market yield therefore should not (and in our case does not) equate to the yield that an active manager of an AREIT Fund delivers investors. However, regardless of whether you are comparing the yield of the sector or the yield of our actively managed funds, AREITs across the board are stacking up very well relative to other sectors in the Australian equities market. This is perhaps contrary to popular media opinion. As risk in the AREIT sector has largely diminished we contend that the market yield is ample compensation for the level of risk that exists.

So, what is the basis for this contention?

1. Risk/reward equation is rapidly normalising

The following chart shows the volatility of the sector (as measured by Standard Deviation) over the last seven years. Clearly the AREIT sector has reverted back to the levels of volatility (risk) displayed pre GFC.

Click to enlarge

We compare the yield of the AREIT sector against other ASX sectors. The following table clearly highlights that the AREIT sector is delivering the third largest yield for FY 2010. The AREIT sector also ranks highly for FY 2011 (6.1%) with a modest 72% payout ratio. On a risk adjusted basis and after allowing for the high level of liquidity in the sector, the yield is clearly attractive.

However, the analysis in fact unfairly underestimates the AREIT sector yield as it ignores the benefit of tax advantaged income. The reality is that the AREIT sector delivers circa 30% tax advantaged component of the income generated.

Click to enlarge

Understandably, for many investors spooked by the fallout of the GFC, a return to the low risk, low returns of cash/fixed interest would be the obvious default investment. However, the time has now come for investors to reconsider investments that deliver sustainable income as well as the potential to deliver capital growth over the medium to long term. AREITs match this description.

Cash versus AREITs

Our regular readers will be familiar with us providing case studies that compare the post inflation return of cash against the APN AREIT Fund based on two different tax rates. Despite the gradual increase in RBA base interest rates over the past two years, as can be seen from the below case study, the APN AREIT Fund is still clearly the preferred option from an income perspective – even before allowing for capital growth!

Click to enlarge

Finally, it’s fair to say that the GFC abruptly changed the payout policies of many AREITs. As the real estate sector suffered deteriorating earnings streams caused by higher debt costs, new equity raisings (diluting distributions per unit) and a reduction in rents, there were widespread reductions to distributions. Furthermore, in the interest of prudent capital management, many AREITs retained a proportion of their actual earnings – the sector average payout ratio is currently 72% (pre-GFC, the ratio was 100%+). As we predicted however, what’s now starting to emerge is that AREITs are getting “some clear air” as they begin to ramp up their payout ratios. A recent example of this trend is the Commonwealth Property Office Fund which recently increased its distribution. We expect others to soon follow.

In conclusion, it’s clear that the AREIT sector is delivering relatively attractive risk adjusted income returns. Pleasingly, the AREIT sector has recalibrated and is returning to the traditional property ownership model the sector was always designed to be and one that APN fully supports. AREITs offer an attractive income focussed investment for investors looking to take advantage of an improving macro environment and steadily improving physical commercial property markets.