In Australia, like elsewhere around the globe, the 2019 outlook for global real estate companies, including property trusts or REITs, is generally stable.
Global economic growth, plus job and wage growth, is driving steady demand, as well as robust occupancy and rental growth. In developed markets, including Australia, manageable funding profiles and sustained investor appetite for the sector should support credit metrics. Nevertheless, we expect the pace of growth to decelerate given the maturity of the cycle and peak occupancy. What’s more, with financing costs rising amid rising interest rates, we think credit quality for the sector globally might have peaked as we enter the late stages of the real-estate cycle.
RISING INTEREST RATES
Faster-than-expected interest rates hikes is a key risk that could pressure earnings and valuations in several global property markets in 2019. The REITS we rate in developed markets, including those in Australia, are generally well positioned to withstand a gradual rising rate environment and potentially weaker economic growth. This reflects our expectations for relatively stable cash flows, limited exposure to variable-rate debt, and generally well-laddered debt-maturity profiles.
We expect REITs we rate in the U.S., EMEA, and Asia-Pacific to withstand a moderate pace of rate increases, with debt coverage ratios such as fixed-charge coverage and EBITDA interest coverage weakening only modestly. We looked at how three levels of interest rate increases–100 basis points (bps), 200 bps, and 300 bps–would affect REITs’ various credit measures, and we found that rated REITs are well-positioned to cope because they have fixed a greater portion of their debt at low interest rates and their liquidity positions are either strong or adequate.
TOP OF THE REAL-ESTATE ASSET-CYCLE
For many REITs, external growth is increasingly difficult to achieve. This partly because assets remain expensive relative to REITs’ cost of capital. The lofty prices across global REITs’ asset classes and the low cost of debt are making previously marginal greenfield developments or asset-enhancement projects viable. Despite high asset valuations, non-traditional real estate players continue to boost asset prices. However, we believe the risk of a liquidity pullback from the trade-affected economies is a possibility given the spectre of a prolonged trade war between the U.S. and China and the subsequent contagion impact on the global economy.
A liquidity pullback could have an impact on the availability of debt for some real estate entities, making it more difficult for them to source new debt financing and roll-over maturing debt. This would be amplified for those REITs that have sizeable short-term debt maturities that require refinancing in unfavourable credit market conditions. In previous stressed property cycles, those issuers that were in the process of completing a sizeable debt-funded asset enhancement program or consummating a large debt-funded acquisition had their credit quality come under pressure.
A liquidity pullback could trigger a wave of mergers and acquisitions, equity raisings, and difficult debt renegotiations, such as those that occurred during the global financial crisis. Another sign we are at the top of the asset cycle is the growing disconnect between public and private commercial real estate valuations. This is evident as REIT equities are trading at a discount while capitalisation rates, which support asset prices, remain relatively steady. This has prompted some REIT managers to implement share repurchases to bolster their equity prices while ensuring they remain within their financial targets and maintain credit quality.
A number of REIT managers are conscious of the current fully priced real estate markets in which they operate. They want to maintain financial firepower to take advantage of potential future acquisitions when the cycle turns.
DISRUPTION: E-COMMERCE CREATE RISKS FOR RETAIL LANDLORDS
Disruption in the retail sector and the development of co-working rental alternatives are forcing some REIT landlords to reshape their leasing strategies, a trend we expect to continue in 2019. As retailers around the world grapple with the accelerating e-commerce growth and shifting consumer tastes, REIT landlords need to seek less-traditional tenants, manage their costs, and focus on the quality of their shopping spaces. In 2019, we think retail property owners will continue to face the following main challenges:
- The steady development of online retail is positive for demand of industrial assets like warehouses or storage depots, but negative for retail space. Online retail is growing at a double-digit pace globally, far outpacing general sales growth. Physical retailers around the world are therefore facing challenging business conditions, in particular “anchor” tenants such as department stores and specialty retailers in fashion and apparel.
- In that context, REITs are actively redeveloping and renovating their assets to lure new retail tenants to malls and drive foot traffic. This is visible in the transition of tenant profiles toward lifestyle, leisure, and entertainment offerings (development of catering areas, cinemas, and gyms). The dividing line between e-commerce and physical stores is also blurring: offering multi-channel shopping options (click and collect, for example) is becoming critical for tenants to remain relevant. Finally, we see retail REITs leveraging big data (collecting statistics on footfall, shopping habits, consumption patterns, and sharing this with their retailers’ tenants) to counter the development of e-commerce.
- Tougher competition between existing shopping centres, with prime international retailers becoming more selective in choosing their limited number of physical store style and locations. We see a clear trend among retailers of cutting the number of shops and concentrate on their best-quality assets. We expect the flight-to-quality to continue among large shopping centre owners, especially in highly competitive retail segments like fashion. Against the backdrop of distress in retail, offering flagship quality stores in the most central locations, accessible through public transportation, is a critical differentiating factor for retail REITs.
Globally, there is a big disparity in retail real estate per capita. The U.S. has long had an oversupply of retail real estate (it is “overstored”), while markets in Europe and Asia are much less penetrated. Lesser shopping density and differences in anchors – European shopping centres are commonly anchored around a food supermarket and not a department store, unlike in the U.S.
POSITIVE SIGNS FOR INDUSTRIAL ASSETS
For real estate companies focused on logistics and industrial assets, the environment is looking favourable. This is despite rising uncertainty around the global trade landscape, in particular between the U.S. and China. Demand for industrial assets shifted into a higher gear in recent years with a boost from the rise of e-commerce, consumer demand for rapid delivery of goods, and the ongoing reconfiguration of global supply chains. To keep tenants and attract new ones, we expect owners of industrial property will further develop their assets’ automation and data collection capabilities over the coming years.
Also, REITs are reconfiguring the type of industrial space they offer to enable more effective “last mile” delivery: smaller depots close to city centres are in high demand. In the U.S. and Australia, rent growth for industrial properties continues to outperform other property sectors as the tailwinds from e-commerce growth and supply-chain investments have generated ongoing strong demand.
The impact of tariffs on industrial REITs have thus far been insignificant because most companies we rate tend to be more consumption-oriented than production-driven. Even though there is continued uncertainty about the tariffs, our current base-case assumption is that the tariffs, if imposed, will have a relatively muted impact on the industrial REITs we rate.
DEVELOPMENT OF CO-WORKING: SHORT-TERM CONTRACTS VERSUS LONG-TERM LEASES
The internet and mobile technology have enabled wider use of freelance employees and shorter-term assignments, and as a result, workforces are more untethered. To accommodate the growing demand for co-working or flexible workspaces, WeWork or Regus concepts are being applied in many countries to new office builds or refurbishment of existing office floor plans. We tend to consider these companies more as service providers, as they source their office space from traditional REIT landlords and then sublease to tenants, exposing them to the risk of duration mismatch between the leases.
By offering shorter and more flexible leases, these companies are also exposed to the risk that vacancies could increase rapidly in the event of an economic downturn, since they typically charge by the month and per workstation. While REITs’ exposure to these co-working concepts remains fairly limited, these working environments are growing at a rapid pace and could potentially disrupt the traditional office real estate sector over the longer term. A key player in co-working, WeWork Companies Inc. has ambitious growth plans and is becoming a prominent tenant in several key gateway markets (WeWork has become the largest private occupier of office space in New York).
Given their rapid growth, we are seeing more traditional office REITs willing to partner with co-working concepts such as WeWork to drive occupancy and enhance the vibrancy of their assets, but many remain cautious in expanding their relationship with co-working startups given untested business models in a downturn. While we do not expect meaningful impact on rated office REITs in 2019, the successful expansion of co-working and flexible space providers, particularly in the large corporate segment, could be a longer-term threat for traditional office landlords and could pressure rent growth and loss of market share to co-working players.
This article was first published in the ANZPJ May 2019 edition. Visit the ANZPJ library to read past publications.