The coronavirus and the property market

Most asset classes have experienced COVID-19 disruption. Grant Atchison looks at how the domestic property sector has fared during these trying times.

While the primary impacts of coronavirus are currently being felt by individuals and communities around the world, the duration and severity of its effect still remain largely unknown.

Here’s what we have seen to date.

A first order impact relates to our health and the ability to continue with our daily lives. Then, the secondary impact – the global reaction to coronavirus, which is a combination of a flight to safety in the investment markets and a restriction on global trade, both within and between countries. This restriction has had an impact on the movement of goods, currency, people and ultimately gross domestic product (GDP).

Listed versus unlisted property securities – different impacts

Depending on the duration of COVID-19, the experience of investors in listed and unlisted property securities may be quite different.

Listed property securities, or Australian real estate investment trusts (AREIT), are exchange traded and valued second to second by the market. This results in an immediate valuation adjustment for any news or investor sentiment. We have seen the impact of this over the past few weeks, with high levels of daily and intra-day volatility.

On the other hand, unlisted property securities are unit priced periodically, monthly, quarterly or annually, on an appraised valuation basis. The trustees of unlisted property securities have a set valuation policy that determines when each asset in the portfolio is valued. Oft en 25 per cent of the security is valued each quarter, resulting in 100 per cent being valued over the full year. This generally prevents an over or underreaction from any individual news event and delivers a less volatile experience for investors.

While AREITs are subject to daily market valuations, the assets held within each listed security are still valued on the same principle noted above for unlisted securities. Because of this, we have seen large gaps emerge between the implied value, based on the price of the listed security, and the net tangible asset (NTA) values that lag.

As a result, in recent weeks several large unlisted managers have moved to revalue their real estate and infrastructure portfolios down by amounts of between 2 per cent to 11 per cent. The harder hit retail sector is generally at the top end of that range and most other sectors are at the lower end of the range.

COVID-19 was the catalyst for the extreme market sell-off late in the March quarter, with AREITs falling more than equities. Whereas previously the AREIT sector had been trading at a premium to NTA, it is now trading at a significant discount. For example, Dexus Property Group (ASX: DXS), has gone from a 15 per cent premium to NTA to a 5 per cent discount, and GPT Group (ASX: GPT) from a 3 per cent premium to its current 19 per cent discount.

Our view is AREITs will be the first to respond on any positive news with respect to coronavirus and we have already seen some of this.

The extreme sell-off has thrown up some attractive buying opportunities. We are currently in the process of attempting to rotate out of a few unlisted positions, in particular some of the wholesale unlisted funds where there is generally some level of liquidity. While these investments have performed well for us, we are of the view their unit prices may be at, or near, their peak and better opportunities are now appearing within the listed sector.

Not all AREITs are the same

It is important to assess the different risk profiles within the AREIT sector because they are not all the same.

At the lower end of the risk spectrum are the passive rent collectors. These AREITs have a portfolio of existing core assets that are generally higher quality, with strong tenant covenants and conservatively geared balance sheets. These securities represent a purer exposure to property assets.

As you move further up the risk curve, there are listed property securities that introduce equity-like risk from more active revenue streams, such as funds management, development projects or operational risk. During periods of strong growth these types of AREITs tend to outperform simply because they carry a higher level of risk.

When the market moves to ‘risk off ”, as it has done recently, the defensive characteristics of the pure property securities provide some downside protection and a more sustainable level of income for investors. Despite this, with the extreme market reaction to coronavirus, AREITs across the sector are withdrawing their guidance provided during the reporting season less than two months ago, and looking ahead we expect to see some cut their dividends.

Different sectors, different impacts

The most immediate impact of coronavirus within the real estate sector, other than being embroiled in the market downturn, has been connected to assets that host large groups of people incorporating a floating population, such as shopping centres and hotels. Foot traffic at major shopping centres is well down and in hotels occupancy is low and cancellations are up.

Our view is AREITs will be the first to respond on any positive news with respect to coronavirus and we have already seen some of this.

For the retail sector, these impacts come on top of the structural changes that have been taking place within the sector. The significant growth in online ’shop at home’ practices, now representing close to 10 per cent of annual retail sales, has led to the balance of power shifting from landlords to tenants and resulted in substantial pressure on retail centre earnings.

This has driven an aggressive sell-off of retail landlords - especially those with a high exposure to discretionary spending such as Scentre Group and Vicinity – given they constitute a significant weight in the listed property benchmark.

In our view, we are witnessing an accelerated and permanent structural change in retail from the combined effects of change of use, online sales growth and now, the coronavirus pandemic.

We have been concerned about the structural changes occurring in the discretionary retail landscape for some time. Our significant underweight towards these stocks was a material contributor to our recent outperformance.

The second group of assets, which also host large groups of people albeit with a more permanent population, include office buildings and social infrastructure, such as aged care, childcare, schools and even prisons. The ability to compartmentalise and control these types of assets is far greater than the first group. Only now are we starting to see the real COVID-19 impact, with companies who occupy these properties implementing business continuity plans with flexible working policies and quarantining taking place.

The final group of assets is more affected from the supply side. This group includes tenants of industrial buildings with logistics operations that are being affected by the restrictions on the movement of goods. Equally, in the residential property sector, the construction industry requires materials to complete properties and then purchasers to acquire completed stock – many, particularly off shore buyers, have left .

Beyond those asset groups are some unique AREIT stories. Viva Energy REIT (ASX: VVR) is one such entity.

Viva Energy owns a portfolio of 469 service stations or convenience retail properties underpinned by 2.2 million square metres of land. It has a highly predictable income stream underpinned by a 100 per cent occupancy rate, average lease expiry of greater than 11 years and fixed annual reviews of circa 3 per cent. The security of this income is enhanced by the quality of the majority of the tenant covenant, with Viva Energy possessing the sole right to use the Shell brand in Australia for the sale of fuel. Conservatively geared at 30 per cent and with the tenant responsible for all additional expenses to the properties, the stock provides a high-quality defensive and predictable dividend yield in the current environment, which, on current prices and guidance, is around 6.5 per cent.

In our view, Viva Energy will be one of the few stocks in the AREIT sector not impacted by the current COVID-19 crisis, given its tenants are well capitalised, continuing to trade and make money in the current environment, while being secured by long-term leases. It is a simple story, but one that should provide investors with stable and secure dividends going forward and steady growth, which is rare given the current macroeconomic backdrop.

What are we doing during this period?

In times like this, it is important to be clear on your long-term investment thesis and interrogate your assumptions as to what, if anything, has changed.

The coronavirus situation has played havoc with the stock market, resulting in some dramatic price declines among stocks. Over this period, the Freehold AREIT and Listed Property Fund significantly outperformed both its benchmark and the broader AREIT universe, reinforcing the offering’s underlying investment principles of investing in high-quality stocks with highly predictable earnings streams supported by either long-term contracts or leases.

Despite the sector possessing strong balance sheets and debt metrics before the impact of coronavirus was unleashed, the devastation to the broader economy has placed enormous uncertainty on the potential income streams of many AREITs. This has also led to massive uncertainty over underlying asset values, causing transaction markets to freeze.

SO WHERE TO FROM HERE

There remains significant uncertainty as to how long we will be facing the current economic climate. In this context, there are very few companies that can provide any real certainty as to where their earnings will land when they next report results.

While balance sheets were broadly in pretty good shape entering this period, we would not discount the potential for capital raisings to occur as corporates look to make their balance sheets bulletproof and not be reliant on debt markets for capital going forward. We also expect some asset values to ‘rebase’ from here, with investors putting a premium on the counterparty with significant evaluation regarding the long-term viability of some tenants.

In summary, we remain in uncharted waters. While we believe the initial sell-off has thrown up some excellent investment opportunities, we also remain relatively cautious on the short to medium-term outlook and will continue to have a bias in the portfolio towards quality.

In the near term, while monitoring our portfolios, we’re largely letting them do what they were designed to do. However, we are ready for when opportunities present themselves to add value to investor portfolios.

GRANT ATCHISON is managing director of Freehold Investment Management.