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Zenith believes that the reason lies behind the combination of a constrained market universe and disparity between the characteristics of certain key AREITs which go against the philosophy of many managers of AREIT funds.
A gulf dividing fund managers
Zenith has noted that as at 31 May 2019, the performance of the peer group median manager relative to the benchmark index has shown its greatest level of annual underperformance in 20 years, as the following chart shows. The data also shows that there has been an abnormal level of return dispersion amongst funds.
Source: Zenith Investment Partners
What is causing these events? What inferences can be drawn? And in the face of such erratic behaviour, should investors switch from active management to an index-based strategy for AREITs?
To answer these questions, Zenith believes that investors must have a clear understanding of the makeup of the AREIT index as well as an appreciation of the different manager mandates and their implications for returns.
Lifting the lid on REITs
The number of countries now offering REITs as an investment vehicle is growing rapidly and as these regimes have evolved, the use of REITs has become more widely accepted as an investor friendly, tax efficient vehicle for real estate investment.
However, in most countries REIT legislation is highly prescriptive, with inclusion tests on a range of issues, including:
In contrast to the rest of the world, Australia has a remarkably accommodating approach to inclusion tests for REITs. While the collective AREIT market sources most of its earnings from real estate directly, there are several key members of the AREIT index sourcing material levels of earnings from real estate development and funds management.
Until the late 1990s, AREITs were pure real estate vehicles and as such, their earnings were relatively predictable in comparison to general equities. However, the rise of stapled securities changed this dynamic.
Stapling usually consists of a trust unit and a share in a funds management company. These securities are ‘stapled’ together and cannot be traded separately. The trust holds the portfolio of assets, while the related company carries out other activities, traditionally property development, funds management and property services.
As this format gained popularity, AREITs were able to add higher growth income streams outside rent collection, thereby transforming earnings growth.
While stapling is a logical way to construct a vehicle mixing rents and corporate earnings, the increase in earnings comes at the cost of increasing exposure to equity type risks which are leveraged to the real estate cycle. Past cycles have shown that investors’ increased appetite for these riskier income streams when markets are buoyant, can reverse rapidly during periods of market turmoil when risk appetite wanes.
Market concentration also plays a part
Australia’s liberal approach to REIT classification is not a major issue in itself. However, the AREIT sector has always been highly concentrated, with the top five stocks typically more than 50% of the market capitalisation and the top ten more than 80%. This is in addition to sector concentration where the majority is held in office, retail and industrial.
Accordingly, the impact of a single event or thematic stocks can move the market materially. For index-based strategies, this creates significant security specific risk in a fund.
However, this also creates issues for active managers. For benchmark aware strategies, it can limit active risk that can to be taken without breaching relative risk limits. While benchmark unaware managers may be less constricted, a view on what constitutes property is another key aspect.
Property is about all income – except when it’s not
In general, REITs are about generating rental income. However, not all AREITs focus on rents for revenue as shown by Goodman Group (GMG) and Charter Hall Group (CHC).
The following chart shows the HY19 earnings breakdown for GMG and CHC, split into property (rent collecting), funds management operations and development. We have also included Shopping Centres Australia (SCP) as a more typical example of an AREIT with high levels of earnings underpinned by rents.
Source: Zenith Investment Partners
It is apparent how little of the current earnings for CHC and GMG comes from rents. These companies (and to a more limited extent others in the index) have variously been the beneficiaries of several key thematics:
These drivers have contributed to a positive feedback loop, resulting in progressively higher multiples being paid to access more volatile and cyclical earnings.
As can be seen in the following chart, relative to the median of the rest of the current index constituents, the share price multiple to NAV of these two stocks has risen rapidly (from an already elevated position) since early 2018.
Source: Bloomberg
For managers taking the view that property should be about the stability of rental income, this creates a conundrum amplified by the concentrated nature of the sector. While CHC and GMG are well managed companies, many take the view that the quality of their earnings is a detractor to those seeking a more traditional, lower risk property exposure.
Huge dispersion of returns in stocks
The material increase in dispersion of fund manager returns over the last 12 to 18 months echoes the high dispersion in individual total stock returns amongst the AREIT index, as shown in the chart below.
Source: Zenith Investment Partners
CHC and GMG have been the key beneficiaries of the above themes. When accounting for sector weights, the individual stock attribution is as follows.
Source: Zenith Investment Partners
Clearly, the impact that GMG and CHC are having on the index is significant. For the 12 months to 31 May 2019, approximately 50% of the total return for the stocks in the index is attributable to these positions (returns do not include the impact of index rebalancing). This is a material issue given these two stocks are significantly less ‘property like’.
What does this mean for investors in active AREIT funds?
When choosing an actively managed AREIT fund, investors should ask themselves:
Given the differences in approach and objectives, some funds have been less able, or willing, to fully participate in the momentum being generated in the index by stocks which are arguably less property like. Others, while tolerant of the broader characteristics of these stocks, feel that general equities investors have been rotating into REITs as a defensive play and are elevating these higher growth attributes beyond a reasonable level for such cyclical earnings.
Funds with an income focus in AREITs also find this environment challenging. Given they typically seek stocks which generate predictable low risk income, they tend to limit exposure to stocks with high levels of non-rental earnings. Also, their yield focus tends to underweight stocks high growth stocks due to their lower dividend yields and higher risk profile. With GMG and CHC currently dominating index returns, such funds have found that their relative performance has struggled.
Should investors switch to an index-based strategy?
In current conditions, many funds have endured short-term poor performance when measured on a purely benchmark relative assessment. As a result, many investors are asking the question, should I switch to an index-based strategy for AREITs?
Zenith believes that the answer to this question should be found in an investor’s objective. For those investors who prioritise low cost and who also have a low tolerance for active risk in their funds, indexing is a perfectly valid solution.
However, electing to adopt an index-based strategy should only be undertaken with a clear understanding of the risks embedded in the index and the investors own objectives. If an investor is utilising AREITs in a portfolio to gain access to stable income, is concerned about stock specific risk, or has as a more purist view of property, then switching to an index-based strategy may not be an ideal outcome at this point of the cycle. This is relevant in an environment where the nature of the index has been changing rapidly and exposure to highly cyclical earnings which can exhibit more equity like characteristics, is increasing.
Assessing the merits of an index versus active approach is a valid question. However, Zenith believes that it is a question that should be asked when choosing how to implement an investment objective, not one taken as a default response to periods of underperformance from an active strategy.
By Dugald Higgins, Head of Property & Listed Strategies.
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