Despite outperforming both Australian equities and unlisted property in the second quarter, September has not been kind to Australia’s listed property sector (A-REITs), with an extended sell-down in long-dated bonds placing greater downward pressure on direct real estate valuations.

New data released by Zenith Investment Partners reveals that A-REITs climbed 3.3% in the quarter ending June 2023, while unlisted property returns fell by a corresponding 4.4%.

For the 12-month period to 30 June 2023, listed property delivered the highest ‘property’ returns at 8.5%, higher than direct property at 1.1% (down from 5.4% last quarter) due to a capital growth reversal, as valuations moved lower with higher bond yields biting.

However, income continues to return around 4.8% over the year.

Interestingly, after having reigned supreme over the 5-year period to June – delivering annualised returns of 12.1% – unlisted property delivered a -2.5% return in the 12-month period.

Source: Zenith Investment Partners 

Sector breakdown

Zenith data suggests the performance of direct property (at the end Q2) continues to diverge by sector, with total returns across the three main commercial property sectors all down on the year prior.

• Retail property total returns remained positive at 2.7%, with income returns offsetting asset value declines.
• Office values continued to decline with total returns dropping to negative 2.5%, with the flight-to-quality-bi-furcation trend continuing with prime Sydney and Melbourne CBD assets.
• The industrial sector’s solid performance persisted, with a total return of 6.6% recorded for the year, with low vacancy rates continuing to support strong rental growth. However, it should be noted that this time last year the industrial sector recorded an annual total return of 22.3%.

Turning point

Despite the positive returns experienced by A-REITs, many listed property stocks continue to trade at a discount to book value, due in part to rising bond yields and investor caution over the likelihood of further asset devaluations.

Given that Australia’s listed property stocks have fallen by around 8% this month – far greater than the broader share market, down 3.8% – investor fear appears justified.

What seems to be having a negative impact on A-REITs is the uptick in domestic inflation following a spike in the oil price, with the US Federal Reserve (The Fed) hinting at sustained higher rates after the US Treasury yield hit a 15-year high.

Closer to home, signs of rising wages growth in enterprise bargaining agreements and persistently high inflation only heighten the risk of another rate hike later this year.

Despite the rocky road experienced by A-REITs, what’s also playing on investors’ minds is the potential impact on the valuations of office towers, commercial property, warehouses and shopping centres.

While the long bond yield arguably has implications for listed property, what remains to be seen, adds Wall Street analyst at UBS, Grant McCasker is how the broader real estate market will continue adjusting to a period of higher rates.

“There’s a huge difference between REIT values and direct market values at the moment, which suggests a lot of downturn for the direct market,” said McCasker.

Source: Zenith Investment Partners 

Pesky inflation

With the consumer price indicator at 5.2% in August, up from 4.9% in July, Bonnie Corbet, investment analyst with Zenith Investment Partners expects all eyes will be on what the new Reserve Bank governor Michele Bullock decides to do when the board meets again next Tuesday.

She expects direct property transaction volumes to remain limited in the quarter ahead, particularly in retail and office sectors where capitalisation rates have climbed.

“Investors remain cautious about weaker consumer spending and office workers continue to work from home. This environment will continue in the quarter ahead, with market participants pausing to assess the impact of further monetary policy decisions.”

Meanwhile, Damian Diamantopoulos, head of research at Australian Unity, believes new A-REITs data highlights the vital role income and assets with strong fundamentals play in a commercial property portfolio.

“While uncertainty around the speed of interest rate rises and increases to investors’ cost of capital have led to a reversal in direct property valuations, it’s encouraging to see the resilience of the underlying income-generating properties of commercial real estate,” said Diamantopoulos.

“With a pull pack in direct property valuations underway and a potential peak in this current interest rate cycle, value is beginning to emerge across both public and private markets.”