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?
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
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
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.
REITs for the year ahead
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.
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.
Emerging Companies Portfolio Manager
Oracle Investment Management