Australian investors love investing in property, and REITs is one of the most accessible means for individual investors looking for income and gain commercial real estate exposure. Real estate makes up a large portion of the listed ASX market with the combined market capitalization of the Australia Real Estate Investment Trusts (AREIT) or Listed Property Trusts (LPT) sector consistently in the top 5 ASX sectors behind financial and mining companies.
The REITs’ popularity is due to its ease and simplicity for investors to gain exposure to commercial real estate. It merely is not feasible for investors to own commercial properties themselves, given the level of management and minimal capital requirements.
One of the greatest strengths of owning REITs is the immediate liquidity it offers. Although investors might not like the bid prices during market sell-offs, there is an opportunity for the exit if liquidity is required elsewhere in the portfolio. It is commonly overlooked that direct real estate asset is an illiquid asset class even during the good times. The time it takes to do a real estate deal can span 3 to 6 months, and liquidity risk is a real risk in this space.
Listed vs Unlisted REITs
Long term investors like super funds have a dedicated portfolio allocation to real estate either directly or indirectly through unlisted property funds. Unlisted property funds are illiquid with investors only entering and exit when there is cash on hand or new investor capital redeem the liquidating investors or assets sales to fund the redemptions.
ASX REITs allows individual investors direct access to a diversified portfolio of real estate in their portfolio in a much more manageable form and limited risk of capital being locked away. The downside of the fund being listed on the ASX is the price can deviate from the net tangible asset, and since it is quoted daily, there is a degree of mark to market risk.
What’s in the ASX 300 REIT Index (XPJ)?
The REIT index is a market capitalization-weighted benchmark of all of the real estate investment trusts included in the ASX 300 index. There is a wide range of A-REITs on the ASX from the traditional sectors (office, retail and industrial) to alternative specialists (large format retail and childcare) and operating businesses such as real estate developers.
List of All ASX REITs
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Read More: Beyond real estate, our ASX ETF list covers all of the exchange-traded funds listed on the ASX.
Sector Exposure
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After Westfield’s takeover by Unibail-Rodamco and Covid, the A-REIT market’s total market capitalization is no longer just concentrated in the retail sector. The listed A-REIT market is now more diversified across multiple commercial real estate asset classes.
Covid Impact on Real Estate Investment Trusts
The listed REITs typically lead the commercial property market’s direction due to immediate liquidity providing price discovery. Today’s all ords index saw a sharp fall in prices, but the listed property trusts performed even worse.
Commercial properties face a different set of risks from the virus. It was pretty grim walking down the street during the crisis and seeing the retail shops closed. Every single shop is someone’s business, and they are facing a very uncertain future.
- The first order impact is the ceases of rent payments, which hit the retail landlords particularly hard. The likes of Scentre (Westfield) and Vicinity has already seen some of this and will continue.
- Longer-term, the effect is still being played out, but the casualty so far for the sector is an existential one where the leases can be invalided during times like this.
- Office landlords with extensive exposure to smaller tenants are also working hard to make sure their tenants are paying rent. Commercial office buildings value will drop, and the only question is by how much.
- New office supply will slow, and the long trend of working from home will affect the demand for the existing stock (sublease vacancy is already rising). Office rents will likely go backward in the immediate future, and subleases open up as corporate try to move the lease obligations off their balance sheet.
Similar to real estate cycles, there was minimal spread between the prime and secondary stock. Overall, office cap rates will blow out, but the better quality assets (premium and A-grade CBD assets) will outperform secondary assets. It just shows it always pays to pay up for quality assets during the good times, and chasing yields will also come back to haunt you later.
Passive investing in A-REITs
A-REITs are known as a staple for investors looking for dividend stocks. REIT ETFs are exchange-traded funds that invest in a portfolio of REITs. Rather than trying to beat the market, these are passive investment funds that aim to replicate the overall REIT market’s return at a low cost. ETFs do not take an active risk, e.g., stock selection, picking winners or losers. Their primary role is to track the benchmark, which represents a portfolio of REITs.
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A-REIT Asset Classes
Traditionally REITs focused exclusively on a single real estate asset class such as office, retail or industrial buildings. For example, Westfield (Scentre) being the best example of a retail REIT that invests exclusively in shopping centers.
Office – Core and core-plus office buildings are the bread and butter of the listed REITs. They often own some of the best Prime and Grade A office properties in Australia and are rarely traded.
Dexus, GPT and Mirvac are the major players in the core office real estate buildings in Australia. A subset of office strategy focuses on commercial office buildings in the metro or non-CBD locations best represented by managers like Centuria.
Combination cap rates and market rents drive real estate value. Office rent is driven by occupier demand (employment growth), supply and general economic growth.
Industrial – Warehouses, logistic centers commonly represent industrial assets and even business parks, but what is not widely known and not shown on the annual report’s front page is that the sector also includes light manufacturing sites (factories).
Market rent for industrial rents is linked to overall economic activity, land release for industrial development, the rollout of eCommerce retailers and land supply constraints in critical industrial markets.
Retail – Retail assets can range from prime shopping centers like Scentre, Westfield operator in Australia, to Charter Hall Retail Trust (SCA), which predominantly owns neighborhood shopping centers, which are centers anchored by 1 or 2 supermarkets.
Developers – REITs are rent collection vehicles that pass on the rents it collects to the trust owners. Developers aim to profit from turning empty lots into something worthwhile.
- The scope of large commercial developers like Lend Lease and CIMIC are diversified across sectors and geographies.
- Mirvac provides office and residential exposure.
- Scentre mostly focuses on the expansion of its Westfiled portfolio in Australia.
- Listed residential developers like Mirvac and Stockland also include aspects of master planned communities in their development pipeline.
Real Estate Fund Manager – REITs can be structured as a stapled units with a real estate funds management business. The earnings are based on the asset management and performance fees it charges on the property funds it manages.
Specialist REITs – Specialist REITs invest in niche properties that are suited for a particular sector. These include healthcare, childcare, data centers, storage and pubs. In contrast, the US REIT market can support several specialist REITs within the same sector. There are limited comparables within each niche due to limited asset availability for competitor funds to gain scale.
Australian REITs were burnt pre-GFC investing in going offshore, and because of their chequered history, most of these funds have now exclusively focused on supporting and developing assets in Australia.
What are the key drivers of REIT returns?
It is important to note that each asset class comes with its own set of risk and reward profile, but there are common fundamental principals which drive the value creation in the sector. This list is not comprehensive but a quick explanation of the factors.
Rents
As with anything in the markets, it is all about supply and demand. In real estate cases, rents represent the supply and demand of the market for the product (property). For example, as employment increases, the demand for office increases, which will drive a rent increase.
Cap Rate
Similar to bonds, real estate can be quoted as a yield. For example that office building trade for 5%. A yield is simple an inverse of the earnings multiple, and as rents increase given the same yield, the value of the asset increases.
Interest Rate
Real estate is inherently capital intensive. The interest rate environment is an important context for returns as debt plays a vital role in funding real estate.
The income stream of a real estate investment trust is typically measured against the 10-year bond as a relative value measure. Hence overall returns in the short and medium-term can be influenced by interest rate expectations.
A-REIT Distributions (LPT Distributions)
Core real estate investment returns leans towards income, and that income being tax-efficient has attracted yield focused investors.
REIT distributions do come with franking credits because the income is not taxed on the trust level before it is distributed to investors. Trusts by law have to distribute between 90% to 100% of their earnings.
Australian company dividends have franking credits because tax has already been paid. AREIT distributions do not have franking credits because it does not pay income or capital gain tax on the trust level. A trust governs the relationship between the trustee and the individual investors. In the simplest sense, trusts collect the income and pass it onto the investors.
Tax-deferred distributions
Distributions are taxed on the individual tax rate. REIT distribution also included a deferred tax component. The tax-deferred component represents the return of capital rather than income. This exists because as REITs collect income, the manager can decide if the payments made to its owners are the income collected or capital the investor put in.
A tax-deferred portion of the distribution means that component of the distribution is a return of capital. Hence tax is not payable, but the same amount reduces the investor’s cost base of that unit, and when the units are sold, the capital gains are calculated off the lower cost base, so eventually, the tax will have to be paid as it is not a free lunch.
Tax-Deferred Distribution example
If the REIT distribution value is 10 cents, which is made up of 5 cents of tax-deferred component and the units’ cost base were $1. Immediately after the distribution, the investment’s cost basis is reduced by 5 cents to 95 cents.