Headline numbers don’t tell the whole story

A cursory look at the headline performance of the Australian listed property trusts, or as they’re now more commonly known, Australian real estate investment trusts (A-REITs), would suggest all is not well. The S&P/ASX 300 A-REIT Index posted a total return of -5.6 per cent in the year to 30 June 2017, underperforming the equities market which returned 13.8 per cent and the underlying direct property market which returned circa 12 per cent.

Yet the headline Index performance can be quite deceiving. Why? Essentially the composition of the S&P/ASX300 A-REIT Index is fundamentally flawed.

Like most indices, it is weighted by the market capitalisation of each security i.e. the larger A-REIT securities like SCentre (SCG), Westfield (WFD) and Stockland (SGP) have a higher weighting in the Index. In other words, size dictates whether an A-REIT is included in the Index; not the merit of a particular security.

Investors are continually reminded not to put all their eggs in one basket and avoid taking concentration risk. We’re told to diversify, diversify, diversify. Yet when it comes to the A-REIT Index it fundamentally fails that test. The top eight A-REITs comprise a staggering 78 per cent of the Index by market capitalisation (Figure 1). That means the performance of these A-REITs is going to have a massive influence on the overall performance of the Index, and therefore the sector. And in the past year, they have.

Figure 1: S&P/ASX 300 A-REIT Index Market Capitalisation – June 2017

Source: IRESS

The median performance of the top eight A-REITs by market capitalisation was -3.2 per cent. The big guns, apart from Goodman Group (14.3 per cent), were hit particularly hard – Westfield (-21.5 per cent), SCentre (-13.4 per cent) and Vicinity (-17.3 per cent) (Figure 2).

Figure 2: A-REITs Performance – 12 Months to 30 June 2017

Source: IRESS

The sell-off in the larger cap stocks was driven principally by two factors. Firstly, concerns about the retail sector (see below) saw Westfield, SCentre and Vicinty sold-off (like several of the listed retailers) despite all three owning some of the best retail assets in the country.

Secondly, in recent years the A-REIT sector has attracted significant inflows from institutional and global capital chasing its attractive yield. However, as bond yields started rising (the 10 year bond yield rose from 2.0 per cent to 2.6 per cent during FY17) the sector’s “bond-like” defensive characteristics become less attractive to some investors, and the larger more liquid A-REITs in particular, came under pressure as some of the institutional and global investors rotated out of A-REITs into other cyclical sectors of the equities market and/or redeployed their capital into offshore markets.

At the other end of the scale, the median performance of the smallest eight A-REITs in the Index was positive 9.9 per cent for the year to 30 June 2017. Of these, Rural Funds Group (27.6 per cent), GDI Property (24.6 per cent) and Arena REIT (27.6 per cent) were the standouts, delivering stellar returns to investors (Figure 2).

Another flaw in the Index is that it only captures 31 listed A-REITs. There are another 15 that are considered too small to be included in the Index. These securities typically have a market capitalisation below $350 million. For the big end of town institutional and global investors, these A-REITs aren’t big enough to invest in. Yet many of the A-REITs outside the Index are well managed, have excellent real estate portfolios and performed well in the past year. A-REITs that fall into this category include Centuria Metropolitan Office REIT (25.5 per cent return) and Australian Unity Office Fund (11.4 per cent return).

Finally, the Index is flawed given its sector composition does not reflect the broader real estate market. Retail A-REITs comprise 45 per cent of the Index, well ahead of diversified A-REITs at 27 per cent, office and industrial A-REITs both at 12 per cent, and specialised A-REITs are a minnow comprising just 4 per cent of the Index. Office, retail and industrial are far more dominate sectors across the real estate landscape.

If we drill down to the underlying asset level and include the retail centres owned by the major diversified AREITs – GPT, Stockland, Mirvac – the exposure to retail is more than 50 per cent of the total assets owned by the sector. Given the structural and cyclical issues currently facing retail, this is a massive bet on the retail sector if you follow the Index. The arrival of international retailers in recent years has reshaped the retail landscape – Zara, H&M and Uniqlo to name a few. At the same time, local retailers such as Dick Smith, Payless Shoes and Rhodes & Beckett have disappeared from the retail scene. Retail sales numbers reveal anaemic spending, and the growth of online retail spending continues to gain momentum, and that’s even before the Amazon juggernaut hits our shores. It’s not surprising then that the median performance of the retail A-REITs in the past year was negative 9.5 per cent.

As the past year has shown, the overall performance of the A-REIT Index masks a wide variation in performance across individual A-REIT securities. FY18 is unlikely to be any different given the way the Index is constructed and the likely on-going short-term volatility in A-REIT pricing. Thus, investors who are prepared to avoid using a passive Index fund (that effectively mirrors the weighting of A-REITs in the Index) and go hunting for individual A-REIT securities based on merit and attractive pricing, or invest with an A-REIT securities fund manager that utilises a high conviction, benchmark (index) unaware investment process, are well placed to deliver returns well above the headline A-REIT Index in the year ahead.

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