Lonsec flags risks in stellar A-REITs sector

Lonsec publishes its 2014 Australian Listed Property Securities (A-REIT) Sector Review

Leading research house Lonsec has warned investors to stay alert for structural risks in Australian REITs as the sector continues to rebuild and prosper.

Lonsec’s 2014 A-REIT Sector Review, released today, showed Lonsec’s peer group of active A-REIT managers achieved returns of 12.7% over the year to 30 June 2014 and 15.4% annually over five years. Investors also enjoyed an annual distribution rate of more than 5%.

However the report also identified several ongoing risks in the sector including significant concentration risk across all 23 funds surveyed, and ongoing shrinkage in the sector due to corporate activity.

Peter Green, Senior Investment Analyst at Lonsec and principal author of the report, said the sector “continued to perform in a stellar fashion in 2013-14.”

A-REITs’ strong returns are the result of several factors. The sector has benefited from cheap funding and a fall in capitalisation rates due to the decline in government bondyields. Valuations of properties have been boosted by strong demand for institutional grade assets from both listed and unlisted entities.

In terms of ratings of the 23 A-REIT funds assessed in the report, there were five upgrades and four downgrades. Of the five that were upgraded, one – BlackRock Indexed Australian Listed Property Fund – was assigned Lonsec’s premier ‘Highly Recommended’ rating.

Flagging risks

The report found that there was significant concentration risk across all 23 funds surveyed. Because of the structure of the A-REIT sector, each of the funds typically has a substantial exposure to a small number of securities. At the end of July 2014, the ten largest stocks accounted for around 89% of the capitalisation of the S&P/ASX 200 A-REIT Accumulation Index (XPJ). The five largest names accounted for about 62%. These figures have remained broadly unchanged over the last year.

A related challenge has been the shrinkage of the sector over the last year thanks to corporate activity and the potential that Westfield Corporation (WFD) could redomicile to the United States. Lonsec believes that this will place greater emphasis on capacity management as a driver of success for fund managers in the sector. Some managers may find that their relatively large size makes it harder for them to generate alpha.

Lonsec notes that investors, and their advisers, need to remember that A-REITs are listed securities and that returns will be subject to normal equity market risks. Some stapled securities, such as Mirvac (MGR) and Goodman Group (GMG) also have large exposures to cyclical earnings streams from property development and asset management. The sector has, however, had a more defensive nature for some time, thanks to the A-REITs’ ‘back to basics’ approach following a disastrous period during the global financial crisis.

“In short, concentration risk is not the only issue that investors need to consider when investing in the A-REIT sector”, said Mr Green. “Nevertheless, the changes to capital structures that were undertaken by corporate managements following the global financial crisis laid the foundations for the strong absolute returns that have been achieved in recent years.”

Active versus passive

Within the A-REIT sector, the average Lonsec manager has been able to justify their ‘active’ fees charged – having generated alpha of 1.1% annually over five years and 1.6% in the 12 months to the end of June. Active managers have successfully fought back against the low cost index strategies that have proliferated over the period.

Lonsec noted that, in a fee competitive environment, A-REIT funds increased their ‘active share ’(i.e. the percentage of the portfolio that differs from the relevant benchmark) through 2013: in particular, more ‘benchmark aware’ managers (i.e. those that face the greatest competition from low cost index funds and exchange-traded funds) made a concerted effort to lift their level of active share.

Nevertheless, Lonsec is agnostic about the ‘active versus passive’ debate in the A-REITs sector. Lonsec accepts that, for more fee conscious investors, an index approach to A-REITs can make sense if investors are comfortable holding such a large exposure to the retail sector.

Conversely, Lonsec believes that investors who are looking for alpha from their A-REIT exposure should consider an active manager. “There are several aspects that we seek from active managers”, notes Mr Green. “These include experience ‘through the cycle’, as well as proprietary commercial property experience. We also look for a less ‘benchmark aware’ approach, which means that the manager can take meaningful positions away from the ‘top ten’. Finally, we like to see the depth of research coverage, so that the manager can thoroughly investigate smaller, or non-index, opportunities.”

Other key findings of the report include:

– There have been limited new entrants in the sector outside of the ETF/index space.
– Many A-REIT fund managers that are focusing on the sector have been creative in attempts to reduce concentration risk. Some have invested in globally listed property securities or listed infrastructure securities. Others have taken larger active positions in A-REITs that lie outside the ‘top ten.’
– The merger of Westfield Retail Trust (WRT) with Westfield Group’s (WDC) Australian and New Zealand businesses to form Scentre Group (SCG) reduced the need for the A-REIT fund managers to spend a disproportionate amount of time analysing one stock. Before the deal, WDC and WRT accounted respectively for 27% and 10% of the benchmark. Afterwards, SCG accounted for 19% of the index; the slimmed down Westfield Corporation, for 16%.