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Commercial property’s defensive qualities missing
Australian real estate investment trusts (REITs), often considered a defensive component in a portfolio, suffered the biggest fall of any asset class in March, according to Morningstar’s review of returns for the month.
Australian REITs were down 35.2 per cent last month and down 34.3 per cent over the March quarter. Global REITs also performed poorly – down 24.8 per cent for the month and 30.1 per cent for the quarter.
It is not hard to see why the value of commercial property securities has fallen heavily. The Reserve Bank of Australia’s latest Financial Stability Review says that prior to the pandemic, the retail sector of the commercial property market was facing challenging conditions due to weak consumer spending and heightened competition.
“The outlook for tenant demand for retail property has deteriorated, given the downturn in trading conditions, with declines in rents and increases in vacancies,” the RBA says.
Commercial property is generally considered a defensive asset, with income from long-term leases providing bond-like returns. The investment case for listed real estate securities is that it provides most of the benefits of direct real estate with the added benefit of liquidity
The RBA says conditions in office markets were previously strong but these are also expected to deteriorate in the period ahead. An above-average volume of office supply is due to be delivered into the Sydney and Melbourne CBD markets this year and demand will be unlikely to keep pace with this stronger supply.
It says asset valuations in property markets had increased to very high levels over recent years, both in Australia and overseas.
“In the period ahead, declines in both sales volumes and valuations are likely, reflecting the weakness in the rental market and a repricing of risk by institutional investors,” it says.
Quay Global, a specialist asset manager investing in real estate securities, says industrial and office properties continue to trade well above replacement cost in most markets, and if the economic crisis lingers “there is room for a meaningful decline in capital values from current levels.”
The Quay Global Real Estate Fund fell 13.3 per cent in March. Its latest performance review says: “Compared with Australian shares and unhedged global real estate the fund performed relatively well, but we remain somewhat disappointed as we believe we could have performed better.
“Our focus has been to build a portfolio that was relatively defensive in the case of market or economic shocks.
“This meant a portfolio with reasonable exposure to defensive sectors such as healthcare-related assets and student accommodation – both sectors that have proven to be resilient in the face of recessions in the past. However, COVID-19 would change the rules, especially with regard to ‘communal’ type real estate.
“In response we significantly reduced our exposure to these sectors very early. Unfortunately, we were slower to reduce our weight to retail, which cost us some performance.”
For investors starting to look for opportunities in the REIT market, Macquarie Securities says: “We have reviewed which investment style consistently performs in recessions and declining markets. It is no surprise that portfolios tilted towards quality consistently outperform the broader equity market.
“Quality is measured using return on equity, cash-backed earnings and financial leverage. Mirvac, Goodman Group, Stockland Group and GPT screen as quality in the A-REIT sector.”
Industrial and office sectors remain Macquarie’s “most preferred”, with underlying tenant covenants that are relatively more resilient in a COVID-19 impacted economy.
Macquarie says: “Retail malls are facing increasing pressure to offer rental abatements to tenants. Residential markets are likely to face near-term settlement delays, defaults and lower sales volumes.
“Dexus, Goodman Group and GPT are our preferred defensive names, while Charter Hall and Mirvac Group should have good leverage when the market focuses on Post COVID-19.”
“We downgrade Lendlease to neutral factoring elevated risk in timing of development returns resulting in downside risk to the balance sheet.”
