Watch this space

Across various asset classes, AREITs* have been amongst the most visibly affected by the coronavirus lockdown. Government-imposed ‘stay at home’ measures had an immediate and dramatic impact on mobility, affecting foot traffic to malls in particular. The AREITs index was marked down sharply in March and has been slow to recover as investors digest the impending impact on income. But is the extent of the fall really warranted given the longer-term prospects?

Earnings for 2020 remain difficult to forecast and will remain so while social distancing measures remain in place and while the potential for a second wave of the virus remains a possibility - even as restrictions are eased. However, with the market dust starting to settle, experienced AREITs investors are turning their attention to 2021 on the assumption that the worst effects of the coronavirus will have passed.

But even that far out, prudence is merited. Vacancies will be a challenge for mall landlords as will be calls for lower rent. Taking a conservative view on both (for example, assuming 25% vacancy on specialty stores) delivers an earnings forecast for 2021 some 30% below the 2019 level. But given the sharp fall in the underlying share price, even forecasts that conservative deliver attractive valuations.

Maybe some believe that even these forecasts are too optimistic. After all, hasn’t the lockdown revealed the benefits of online shopping? Perhaps – and we may well see a surge in the ecommerce uptake (from current levels of @ 10% of total retail sales), but it would be a bold forecast indeed to suggest that the mall experience is over, particularly for the higher quality locations.

Other AREIT sub-sectors are also at risk of lower earnings as the full extent of coronavirus is discounted. For example, office tenants are not immune to an economic downturn and vacancies here will also likely rise. Longer term, the office model itself may need to be re-thought as office-workers surprise themselves with how seamlessly they have been able to work from home – as one commentator noted, ‘we know we can do it now’. However, it may be premature to price in too permanent a change in the short term, particularly while restrictions persist.

But uncertainty can also be a time of opportunity. Prospects for some segments are clearly challenged in the short term, but it is far from clear that business models are broken. We can also expect that business models will evolve where necessary – as they have in the past – if the ‘new normal’ merits change.

But while there is so much focus on the short-term disruptions – and opportunities – what about the longer-term prospects? We’ve seen large drawdowns happen before in the AREITs asset class, which ultimately turned out to be a striking opportunity. The annualized 10 year return for the AREITs index from the depths of the GFC in February 2009 was nearly 15%, with quality active managers able to deliver in excess of that.

The GFC brought massive financial dislocation, a big drop in real estate values, an economic downturn that caused a drop in demand and consequently a drop in occupancy and rent, yet the sector went on to stage a multi-year recovery. The market sometimes misprices risk and these inefficiencies create the opportunity for active managers to add a lot of value.

Looking at a period that includes the latest drawdown, the annualised total return for the sector to 30 April 2020 has been 8.2% pa. This seems about right as a long-term real estate return, being a yield of approximately 5% plus 2-3% pa growth. Notably, this return trumps domestic equities** by over 2% pa. Perhaps it’s time to do more than just watch this space.
 

*Australian Real Estate Investment Trust

**The S&P/ASX 300 Accumulation Index had a total return of 5.9% pa for the 10 years to 30 April 2020
 

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