The Ultimate Guide to Real Estate Investment Trusts
Real Estate Investment Trusts (or A-REITs in Australia) are seen as a substitute for direct property investing, with enhanced liquidity. Real estate investment trusts invest in investment-grade commercial real estate to generate yield returns for investors, along with buying and selling properties in line with their investment strategy. They are the only property funds publicly traded on the ASX, with the first trusts listing in the early 1970s.
Australia’s model for real estate investment trusts is a recognised world leader. From less than $5bn in the early 1990s, the sector now has a market capitalisation of $140bn as of December 2020. The A-REIT (S&P Property 300) accounts for around 7.0% of the S&P/ASX 300 Index.
Real estate investment trusts own many of Australia’s top quality commercial buildings, including leading regional shopping centres and many of the prime commercial office buildings in the country.
The real estate investment trust sector has become increasingly specialised. For the first two decades A-REITs were usually diversified portfolios, both geographically and by property type. However, since 1992 most new trust listings have been sector-specific (for example, only office or only retail), with the emergence of overseas vehicles since 1996.
Sector specific versus diversified trusts
As at December 2020 sector-specific trusts represented 65% by market capitalisation of all real estate investment trusts in the sector. The rise of sector-specific trusts has been primarily driven by demand from investors who prefer to choose which sectors they want to invest in.
The A-REIT sector is forever evolving. For many years trusts with domestic office and retail portfolios dominated the real estate investment trust landscape. Then in the years prior to the Credit Crisis global expansion by Australian property managers led to the listing of Australian listed trusts which own assets in many offshore markets.
In more recent times we have seen the emergence of real estate investment trusts which invest in domestic alternative property sectors such as childcare, data centres, seniors living, and service stations.
Another trend has been the dominance of industrial focused real estate investment trust over retail and office ones, reflecting the growth in online retail and the demand for logistics space.
Residential property investment has yet to appear in Australian property trusts, as the yields are lower than those of commercial property. In North America, however, where yields are higher, apartment property trusts are more common.
Residential development is, however, a component of a few groups, with Mirvac and Stockland both generating more than 15% of revenue from residential development.
Internal versus external management
Historically, A-REITs adopted a external management structure. However, over time these structures have evolved and now there also exist management structures which are internalised. Historically, however
With an external structure, the manager receives a fee from the trust (usually a percentage of total assets) for managing the trust on behalf of unit-holders. The manager then employs the necessary people and other resources to manage the trust. A typical management fee is 0.50% of total assets.
Internally managed (stapled security) comprises one unit in the trust being stapled to one share in the company. The units and shares are only traded jointly as stapled securities and cannot be transferred or otherwise dealt with separately in any circumstances. As units and shares are stapled, further units cannot be issued to any other person without the issue of the corresponding number of shares and vice versa. The internally managed vehicles have company overheads rather than a management fee paid to an external group.
There are advantages for and against both structures. Ultimately, the performance of the trust/staple should depend on the quality of the management team and its ability to manage assets and buy/sell well rather than the structure. The Australian listed property trust market offers investors exposure to both structures.
Factors affecting performance
The following factors have an impact on the performance of the real estate investment trust sector.
- Bond yields – Real estate investment trusts are often considered to have an inverse relationship bonds. This is theoretically based on the relative yield attractiveness of the two asset classes and the implies interest charges which are paid by A-REITs on the borrowings.
- Equities – The broader sentiment in the share market, unsurprisingly, will impact the performance of real estate investment trusts. A-REITs are typically considered a more defensive sector on the ASX, with higher income levels and less earnings volatility.
- Capital raisings – A large amount of supply in a short period may impact the sector’s performance if supply exceeds demand.
- Property security funds – Strong inflows will help to underpin the sector’s performance. Property securities funds will be fully invested at most times.
- Balanced/equity – Balanced/equity switching into, or out of, the sector may impact prices. Balanced fund investors will generally maintain a core weighting to the LPT sector.
- Retail investors – Ongoing buyers of the sector reflect a high cash yield and earnings certainty. Ageing of the baby boomers is likely to further underpin this investor group’s preference for yield-based investments.
- Overseas investors – Overseas investors will switch into or out of the sector based on their views of the equity market and the Australian dollar.
- Prospective yield – The real estate investment trust yield relative to bonds is considered by equity/balanced fund investors and the A-REIT yield compared with cash is considered by retail investors.
- Earnings growth – Sustainable earnings growth of c3% pa should be achieved in this property cycle.
- Premium/disc to NTA – Premium/discount to NTA compares A-REIT prices to underlying property values (independent valuation). Property valuations are undertaken by independent valuers and reported in their interim and final accounts (ie book values are updated for revaluations). However, assets may be valued only every three years, so some valuation lag exists. Also, valuations tend to be backward looking, whereas the market is more forward looking.
- 12-month IRR – Yield plus earnings growth expectations post capital expenditure plus adjustment for any bond yield movement.
- Management quality – One of the key factors in driving real estate investment trust returns. A quality manager should extract high returns from its portfolio and buy/sell well.
- Underlying property markets – Given real estate investment trusts are used by some investors as a surrogate for direct property investment, real estate investment trusts returns over the longer term may generally reflect underlying property market fundamentals. For example, if the office sector is suffering from weak tenant demand and rising vacancies, then office trusts may underperform, reflecting investor expectations for limited rental growth (or rent declines) in the near term and possible increasing leasing risk.
Performance of Real Estate Investment Trusts
The following chart highlights the total return performance of real estate investment trusts (A-REITs) relative to commercial property, Australian shares, and Australian bonds.
Over the past 10 years A-REITs have outperformed Australian shares but underperformed commercial property, delivering an annualised total return of 9.2%.
Total Returns to June 2020
|Bonds||Australian Shares||A-REITs||Commercial Property|
Bonds – Bloomberg Australian Composite Bond Index
Shares – S&P/ASX 200 Accumulation Index
A-REITs – S&P/ASX 200 A-REIT Accumulation Index
Unlisted Property – MSCI IPD Index
Looking at returns on an annual basis, A-REITs have been less volatile than Australian shares but more volatile than commercial property, as seen in the following chart.
Real Estate Investment Trust Valuation
The main valuation approaches for real estate investment trusts are relative yield, net tangible assets, and earnings multiples.
The most obvious tool for analysis in a sector that is dominated by income generating assets is to compare A-REIT’s based on their yield. Whilst this is a useful method, investors need to consider the different payout ratios across the sector.
As interest rates continue to fall, investors remain very focused on yield, and given many investors look to the A-REIT sector for income, Yield will likely continue to be a key determinant of valuation.
The following figure shows historical yields for A-REITs relative to 10 year bond yields.
Net Tangible Assets
Net Tangible Assets (NTA) is often a quoted valuation metric for A-REITs. Investors in A-REITs are aware that the underlying investments are real assets and therefore share prices should reflect this.
Often investors undertake a NAV valuation which effectively calculates a one year forward NTA. A NAV will typically make assumptions about the expected cap rate of the property portfolio and derive a valuation based on current income. In addition it will apply earnings multiples to other income streams and adjust book values for non-income producing assets.
The following figure shows historical A-REIT NTA valuations over time.
While real estate investment trusts aren’t often known for their earnings growth, the evolution of stapled structures in the sector has seen a number of trusts demonstrate earnings more akin to other types of listed shares. In these instances it may therefore be more appropriate to value these securities on an earnings multiple relative to their earnings growth.
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