Investing in REITs – is it a good investment?

“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.

While these headlines are related to the residential property market, similar headlines could have been used for listed real estate investment trusts (REITs) in 2022. With the S&P/ASX 200 A-REIT Index down -20.46% in 2022, investors may be asking if the decline will continue in 2023.

At Oracle we have performed research that suggests REITs could have a positive year despite the increase in interest rates continuing.

What is a REIT?

A REIT is a company that owns, operates, or finances income-generating real estate properties, such as shopping centres, offices, apartment buildings, and hotels. The purpose of a REIT is to provide investors with exposure to real estate assets, without the need for direct ownership.

The Australian REIT market has grown rapidly in recent years, with several new listings and an increasing number of investment options available. This growth has been driven by multiple factors, including low-interest rates, a stable economy, and the desire among investors for income-generating investments.

Advantage of REITs

One of the key advantages of investing in REITs is their ability to provide regular and stable income. To avoid taxation at the trust level, REITs are required to pay out at least 90% of their taxable income to shareholders in the form of dividends. This makes REITs an attractive option for investors seeking a reliable income stream, particularly in a low-interest rate environment.

The key to the preceding sentence being “in a low-rate environment.” So, how attractive are REITs now that we are in a rising interest rate environment? That’s the million-dollar question and it is fair to say that the default response from investors would be that if interest rates continue to rise, property investment becomes less attractive. This may be true for residential property investment, however there are a few key factors with REITs that could offset this headwind.

REIT Performance History

With interest rates in Australia forecast to rise by another 50 to 100 basis points, it would be fair to assume another tough year for real estate investors. However, historical data suggests that during the last 7 RBA tightening cycles (interest rates increasing), Australian listed REIT’s have returned on average 7% p.a.

Source – APN Group

To decipher the above data, we need to think about what causes the RBA to increase the cash rate. It is an environment with low unemployment rates, wage growth and increased consumer spending, pushing inflation higher. With rents mostly tied to Consumer Price Index (CPI), revenues will increase during the cycle and stay at these new elevated levels once interest rates stabilise. Combine this with declining gearing rates, 27.5% average compared to 46% 15 years ago, then REITs are set to benefit once interest rates peak.

Taking this one step further, the investment team at Oracle has taken the past 30 years of RBA cash rate data and overlaid that with the 30-year performance chart for the S&P/ASX 200 A-REIT Index (XPK Index). While it would be fair to assume a negative correlation between cash rate movements and A-REIT returns, the chart below demonstrates that interest rate movements don’t always drive real estate returns.

Reviewing the chart above and specifically, the period from 2001 to 2009, there is a positive correlation between the two data points. Investors, however, weren’t buying into REITs in this period due to the cash rate, but rather they were looking for safer investments post the dot-com crash which scared a generation of investors away from internet stocks.

REITs for the year ahead

There is talk and worry that property valuations will be revalued lower this year. As interest rates rise, capitalisation rates (cap rates) on property increase. The cap rate is essentially the discount rate used in the property sector to value the expected future cash flows from the asset. Higher cap rates result in lower property values as investors expect a higher return on their capital.

To explain further, investors can now receive higher risk-free returns from Government bonds, as interest rates have increased. Investors then expect higher yields from REITs (and other investments) as they are taking on risk. This can push property valuations down, increasing yields. It is expected that cap rates will increase in 2023 across the REIT index, however there are some sectors that will be more affected than others.

For example, office REITs may see valuations decline due to subdued leasing activity as hybrid working takes hold. On the other hand, REITs that specialise in healthcare and non-discretionary retail will have relatively stable cap rates as landlords can increase rents in line with CPI. It is for this reason we have recently decreased our weightings towards the aforementioned and increased our weightings to the latter mentioned in the Oracle Property Securities Portfolio.

Summing up

When considering investing in REITs, it is important to consider several factors, including the quality of the underlying properties, the management team, and the financial health of the company. Investors should also consider the dividend yield and the potential for capital growth, as well as the overall risk profile of the investment. Given the decline in the index by over -20% in 2022, we expect a better year for the REIT sector.

We believe the Oracle Property Securities Portfolio is well positioned with a focus on REITS that are trading at a discount to their net asset value, have low gearing levels and are at lower risk of asset devaluation.

If you would like to discuss your investment strategy with Oracle financial adviser Call us today!

Written by Jack Magann
Emerging Companies Portfolio Manager
Oracle Investment Management

Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.

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