A-REITS set for capital growth as sector outperforms equities

The Australian Real Estate Investment Trust (A-REIT) sector outperformed the broader equities market over the year to September 30.

A-REITs returned 28.9% compared with 14.5% for equities.

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And they are forecast to continue to provide both distribution and capital growth. This is expected to be as a result of lower debt service costs, the opportunity to redevelop portfolio assets and the potential for a reduction in the currently high distribution yield premium to the risk-free rate.

A-REITs have been taking advantage of low interest rates by refinancing. While there is a cost associated with refinancing, the benefit to earnings of a lower ongoing interest rate is lower debt service costs. Among those A-REITs to have refinanced with lower debt costs are Centro Retail Australia and Goodman Group.

Tight vacancy rates across the office and retail sectors will encourage the redevelopment of assets held in portfolios. On completion of property redevelopment, the rental yield on costs is high relative to outright asset acquisition. The asset value will increase as a result of the redevelopment.

This redevelopment income into A-REITs will compensate for slowing office leasing activity, lower specialty and department store sales, which have put pressure on rent growth and slower residential development lot sales.

Mirvac and Westfield Group are among the A-REITs with substantial asset redevelopment pipelines.

The 10-year government bond rate is the risk-free rate.

The difference between the A-REIT yield and the bond rate represents the premium offered by A-REITs.

This premium compensates for the business risks associated with A-REITs.

The current A-REIT sector distribution yield is 6.2%, which sits significantly above the benchmark 10-year bond rate of 3%, giving a current premium of 3.2%.

The five-year average A-REIT yield premium is 1.8% above the 10-year government bond rate. The difference of 1.4% between the current premium and the five-year average represents potential for capital gain from yield tightening as the premium reverts to mean.

This combination of lower debt funding costs, the potential redevelopment activity of properties already held in portfolios and the relatively high yield premium will provide the scope for A-REIT distribution and capital growth over the coming year.

Mark Wist is senior asset consultant at Atchison Consultants.