A-REITs with higher potential returns come with higher risk

Ownership of property provides investors with an interest in its net income and affords prospects of capital appreciation through improvements in that net rental income generated and any positive changes in capitalisation rate. Investment into an Australian listed real estate investment trust (A-REIT) provides similar entitlements on a proportional basis, providing an efficient structure for property ownership and transactions. 

Income attributes from A-REITs can vary depending on the source and nature of the income. A conservative A-REIT will derive its revenue from a high proportion of contracted rental income. Other A-REITs supplement earnings with corporate activity such as property development; property management; asset management; fund management; fees from transactions; and leasing services. 

But with this higher return generated by profit comes higher risk. As a trust can’t undertake profit-making activities in its own right, an associated company is “stapled” to the trust to undertake the corporate activities. In this way, these fees and profits are retained within the wider entity (the trust component “stapled” to the company component) rather than being paid to a third party.

Examples of these stapled entities include Mirvac, Charter Hall Group and Stockland. Each of these A-REITs generates a proportion of its overall revenue from rental collection from the effective ownership of property and another portion from corporate activities such as property development etc. While both Mirvac and Stockland have commercial portfolios, both are particularly active in the residential development sector while Charter Hall is focused on the commercial property sector.

Westfield has two entities listed on the Australian Securities Exchange (ASX), Westfield Group and Westfield Retail Trust. The group is a stapled entity with a significant portfolio of properties in Australia and in overseas markets such as the Unites States and United Kingdom. It undertakes property development, predominantly of properties in its own portfolio, and also funds management and other corporate activities. The trust simply holds a portfolio of retail properties in Australia and New Zealand, which is managed for a fee by the Westfield Group. 

Property development by its nature involves uncertain outcomes. Risk can be ameliorated by the use of fixed-price construction contracts and by pre-leasing or pre-selling components of a proposed development, but rarely is all risk mitigated, such as construction delays caused by inclement weather. This variability in the profitability of its activities can be beneficial or detrimental to overall entity earnings, however A-REITs with corporate earnings are often associated with a higher earnings growth profile. Within the corporate earnings component, property development is a higher risk activity than funds management. 

In essence, the income generated by property is relatively stable. The introduction of alternative sources of income including development profit, transaction and fund management fees can shift the characteristics of an A-REIT investment away from underlying property fundamentals and increase income volatility. This may bring a stronger earnings growth profile to compensate for additional risk. Careful examination of the composition of earnings is warranted prior to investment – no two A-REITs are the same.

Mark Wist is senior asset consultant at Atchison Consultants.