The S&P/ASX 300 A-REIT Accumulation Index gave back much of its prior quarter’s gains, falling 6.7% in the quarter ending 31 March 2022. The property index significantly underperformed the broader equity market, with the S&P/ASX 300 Accumulation Index up 2.1% in the quarter.

We have long warned that property is an interest rate sensitive sector and that has been particularly true in recent times. With a reopened, yet more unstable world, inflation pressures appear to be building. In response, interest rates have moved meaningfully higher.

At the start of the quarter the Australian ten-year Government Bond yield was 1.7%, however, by the end of the quarter it moved to 2.8%. Whilst direct transaction and valuation markets have not reflected this sharp change, equity markets are somewhat more forward looking. Australian Government Bonds are considered to be a proxy for a risk-free asset. As such, many investors consider the return of risk assets relative to this yield figure. Many property investors consider the spread between capitalisation rates and this ‘risk-free’ yield. Should capitalisation rates expand to match the move in government bond yields, valuations for properties will move backwards. All, however, is not lost, with many arguing that investors had not fully priced in prior bond yield compression, leading to historically wide spreads between capitalisation rates and bond yields. How much ‘cushion’ was in those spreads will likely become apparent in the medium term.

Property fund managers are particularly sensitive to interest rates and were unsurprisingly amongst the worst performers during the quarter. The strong demand for access to investment property and ever compressing capitalisation rate has been supportive for fund managers in recent years. This dynamic has led to increased base fees, as assets under management grew rapidly. Furthermore, fund managers benefited from increased performance fees and an ability to earn large sums of money on property development activity. Reflecting the more uncertain future, Charter Hall Group (CHC) fell 19.8%, whilst Goodman Group (GMG) gave up 13.6%. Smaller fund managers also underperformed, with Centuria Capital Group (CNI) losing 17.7% and Elanor Investors Group (ENN) off 8.4%.

Truly reversing recent trends, shopping centre owners were outperformers for the month. Sales within shopping centres are obviously very much linked to inflation, so recent events have been far less impactful and, in some cases, may be beneficial for shopping centre owners. Vicinity Centres (VCX) led the way, rising by 13.1%, whilst offshore firm, Unibail-Rodamco-Westfield (URW) moved 8.9% higher. Scentre Group (SCG) lost 1.2% in the quarter, however still outperformed the broader property index.

Office property owners mostly moved lower in an absolute sense but were outperformers over the period. Office rental metrics appear to have somewhat stabilised after a reasonably negative period and transactions that have taken place have been supportive of book valuations. Dexus (DXS) closed the quarter 1.5% lower, GDI Property Group (GDI) was off 1.3% and Centuria Office REIT (COF) lost 4.2%.

Elsewhere, Charter Hall Group (CHC) and entities associated with 360 Capital Group (TGP) are closing in on finalising the acquisition of dual-listed office and industrial property owner Irongate Group (IAP). The $1.90 offer price represents a premium of 21% to the prior closing price.

Market outlook

February’s reporting season was broadly positive for property stocks. Investment property valuations moved higher, although the rate of change has most certainly slowed. Earnings were also solid across all sub-sectors and outlook statements remained robust.

The industrial sub-sector continues to be the most sought after, given the tailwinds of e-commerce growth, the potential onshoring of key manufacturing categories and the decision by many corporates to build some redundancy into supply chains to cope with current disruptions. All of these factors will support ongoing demand for industrial space.

The jury is still out on exactly how tenants will use office space moving forward, albeit demand for good quality, well located space remains robust, and transactional activity of office assets continues to provide ample evidence of value.

We remain cognisant of the structural changes occurring in the retail sector with the growing penetration of online sales and the greater importance of experiential offering inside malls. Recent events will likely accelerate these changes. As Australia re-opens, physical retail sales are likely to pick up and test new highs, as seen during sporadic periods of more limited restrictions. These factors are well understood and the trajectory to a new ‘normal’ is only now beginning to reveal itself. This explains why retail stocks have been the most volatile of all property sub-sectors.

The recent increase in bond yields does present a headwind for all financial assets, and particularly yield based sectors such as property. However, with key large capitalisation REITs trading at a discount to the value of their underlying assets, with no value ascribed to embedded active businesses, we believe the sector offers value.

Phoenix has for some time discussed the risk of inflation, given the enormous fiscal stimulus and extreme monetary policy setting that we now live with. In very recent times, commentators and bond markets have begun to react to the presence of such a risk. In this environment, long leases with fixed rent bumps, which were previously in high demand, may become relatively less attractive. Historically, real assets such as property and infrastructure have performed well during inflationary periods.

About Stuart Cartledge

Stuart is the Managing Director of Phoenix Portfolios and the portfolio manager for each of the company's property portfolios. Prior to establishing the business in 2006, Stuart built a strong track record in the listed property security asset class and has been actively managing securities portfolios since 1993. Stuart holds a master's degree in engineering and management from the University of Birmingham and is a Chartered Financial Analyst.

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