This article originally appeared in Fear & Greed.
Description
Commercial property has had its share of headwinds. New data shows deal flow in the sector has dropped significantly – but much of the pressure is on office towers. Other parts of the sector are performing comparatively well.
And in the middle of it all are Real Estate Investment Trusts, or REITs.
Matthew Strotton is the Executive Director, Head of Real Estate at ASX-listed RAM, which stands for Real Asset Management. He gives Sean Aylmer a 101 on REITs – what they are, how they work, and the outlook for the sector.
RAM is a supporter of Fear and Greed. This podcast contains general information only. You should seek professional advice before making investment decisions.
Sean Aylmer:
Welcome to the FEAR & GREED Business Interview. I’m Sean Aylmer. The commercial property sector has had its share of headwinds lately. New data from MSCI shows deal flow in the sector fell by almost half to about $ 40 billion, dragged down by office towers with so much uncertainty over the future of the workplace. But commercial property investing in Australia is much bigger than just office towers. In the middle of it all are the real estate investment trusts or REITs, R-E- I- T- S, REITs. I wanted to find out how they work, how the team behind an ASX listed REIT goes about choosing the property assets within the fund, and what sort of assets are we talking about.
Matthew Strotton is the executive director, head of real estate at RAM, which stands for Real Asset Management, a great supporter of this podcast. RAM runs the ASX listed RAM Essential Services Property Fund. Remember, this is general information only. You should definitely seek professional advice specific to your circumstances before making investment decisions. Matthew Strotton, welcome to FEAR & GREED
Matthew Strotton:
Thank you, Sean. Great to be here. Great to see you again.
What is a Real Estate Investment Trust (REIT)?
Sean Aylmer:
Can we start with a 101 on REITs, on real estate investment trusts? Many out there know exactly what they are, but many don’t. It is a massive part of the market, but incredibly diverse as well. So what are we talking about when we talk about REITs, and particularly how diverse some of those assets are?
Matthew Strotton:
A great question, Sean. Real estate investment trust, it’s quite a descriptive name, quite a descriptive acronym. It is typically a collection or a portfolio of real estate assets and oftentimes there is one distinction beyond that and that is whether or not a manager is actually internalized or an externalized manager. So at the core of a real estate investment trust is a portfolio of pure commercial, typically commercial real estate, and whether or not a manager is actually part or embedded within that vehicle or it’s an external manager is one of the main differences. As you pointed out, the commercial office market is quite a significant part of the real estate sector and therefore no surprise that the majority or certainly a significant number of real estate investment trusts are comprised of office assets in Australia. All of the other real estate sectors are reasonably well covered, including retail assets or shopping center assets. These are shopping center assets that can range from the assets that are some of the largest in the southern hemisphere, like Chadstone, through to smaller real estate assets like supermarket- anchored, Woolworths and Coles- anchored assets, through to even smaller high street assets. And then beyond that, we do have an array of residential based real estate investment trust. These can include student housing, they can include the growing build to rent asset types that are emerging in Australia, and through to two of the asset classes that I will call out, which is two of RAM’s focus, which is the healthcare or medical sector, which typically contain at the top end of the spectrum private and public hospital.
These are assets that can, as you’d imagine, contain a longer term leasing commitment from either public or private operations that provide services in the hospital sector. These can be overnight hospitals, full service hospitals, they can be day hospitals. Through to other aspects of healthcare including IVF, mental health hospitals, and other allied healthcare. And beyond that, there are other smaller sub- sectors like we call essential services retail, which is your daily or weekly needs visitation for the type of retail assets including supermarket- anchored and other localized retail offerings. And then you have other REITs that do cover everything from service stations and so on. But the broad intention of REITs is to house a collection of real estate assets and derive what is typically a sustainable rental income from those portfolios.
How do interest rates affect REITs?
Sean Aylmer:
That is a great explanation. And the bottom line is real estate investment trusts are trusted invest in real estate, which is stating the obvious, but real estate is such a broad… So it really is across the spectrum. They haven’t done so well in more recent times. Tell me how interest rates affect REITs and then going forward, if REITs start to fall, what that means.
Matthew Strotton:
That is a very good question, Sean. The one central feature of REITs is the level of transparency. Naturally in a listed environment, and including myself as well as all of our peers, are subject to the regime that exists under the ASX, which means regular reporting, which means regular updates of our valuations of our assets, which are conducted by third parties. And on that particular point, Sean, I’ll call out that most of your viewers would no doubt be aware that the valuation of real estate, longer term commercial real estate is linked to a cap rate, and a cap rate is typically linked to what or what is representative of the sustainable income that can be attributed to a piece of real estate.
In the stronger points of the real estate cycle there have been examples where high grade commercial office, even supra- regional real estate, can be used priced as low as a 4% cap rate, and cap rates can vary beyond that depending on the asset quality, the asset location, the sustainability of that income in terms of how long a lease duration remains on that particular asset, so on and so forth. There is an inextricable link between cap rates and lending rates. And in this particular example, when we witnessed, or as we all witnessed inflation start to move upwards, our reserve banker and therefore lending rates by our financiers within Australia started to increase interest rates. And because that has a natural burden on investment, particularly if I’m holding any sort of longer term debt instruments, I am then going to naturally compare to what is a competitive holding in equity real estate, and that lends itself to increasing the required levels of return in equity returns and thus points to, in this example, a higher expected rate of return on real estate.
Therefore cap rates rise and prices start to reduce. What it does do in an environment where inflation and interest rates did rise quite quickly, it tends to shine quite a light on the particular underlying fundamentals of real estate. I think in periods of the economic cycle where real estate is moving, and as it did coming into the end of this real estate cycle or this interest rate cycle, real estate wasn’t necessarily priced perhaps as individually, shall I call it, as it should have been. I think there were sectors and assets being traded that probably maybe moved a little bit too rapidly up the pricing curve. And in this environment at the moment where pricing has become, as you alluded to in your opening comments, has been a little bit less frequently traded, capital is being a little bit more cautious when it undertakes an analysis of any sort of new acquisition or new disposal. It means the individual fundamentals of assets tend to become far more important in their analysis, and that lends itself to even an even wider curve in cap rates. So cap rates, yes, are inextricably linked to interest rates, but importantly you tend to see a wider spectrum of cap rate across different sectors.
Which sectors are RAM Essentials Services Property Fund in?
Sean Aylmer:
Stay with me, Matthew, we’ll be back in a minute. I’m talking to Matthew Strotton, executive director, head of real estate at RAM. So cap rates/ interest rates, we’re talking about quality of buildings. On top of that, you’ve got things for office, for example, work from home trends, all the post- COVID stuff that’s going on, it makes it a challenging sector just to get your head around, really, maybe not to invest in. What about RAM Essential Services Property Fund? Where do you play? Where do you think the sweet spot is?
Matthew Strotton:
I like our outlook in that we are… Two of our central areas we focus on is in healthcare in the medical sector, and we’ve had some very strong areas of momentum over the last 12 or 18 months in that space, as well as essential services retail, which is those shopping centers that we all visit once a week, twice a week, that either house a Coles or a Woolworths.
Sean Aylmer:
I’m a daily shopper, Matthew. I’d love to be twice a week. Really essential services. Go on.
Matthew Strotton:
There you go. So in quite a short summary form, those particular sectors have remained quite defensive. And when I say defensive, that means our tenants that are housed in our real estate properties, be they private hospitals, day hospitals, supermarkets, the local butcher, the local grocer, or some of those other local services that we visit on a regular basis, have withstood an array of different economic scenarios. And we’ve all experienced that over the last four or five years. So today, looking forward, not only can I speak with such confidence that we’ve endured an array of stress tests economically, and we’ve remained very defensive in terms of our income levels, looking ahead in an environment where we may… Our Australian economy either as a whole or certainly parts of the economy are going to experience more duress, we might start to experience a little bit more weakness in our household incomes or whatever it might be up to this discussion.
It’s going to mean it’s going to put further pressure on the tenants that exist in certain real estate holdings, and I would rather in this environment have a more substantive exposure to healthcare, which is… I think that the fundamentals of healthcare, why it’s remained resilient, I think is self- evident, but also in that essential services retail class. You talked about office and it being subject to disruption, like retail has been subject to disruption over the last 10 or 15 years as we’ve absorbed and seen the flow- on effect of a change in behavior in the manner in which we shop. But there’s one thing about real estate, there is always going to be an underlying level of demand that is always pinned to both population growth, income growth, and other demand drivers that is always going to underpin the longer term fundamentals of a particular sector.
When we talk about disruption, like you hinted at with office, those impacts tend to be absorbed within a period of time. I think office has… Yes, it’s gone through an interesting cycle, but I might suggest, like a lot of our peers are describing at the moment, that office has absorbed that impact. The underlying demand for space is certainly reemerging and you’re starting to see quite a level of interest back in that particular sector. But not withstanding all of that, when you add all of those features up, it’s easy to describe real estate perhaps in a cap rate on one hand, but on the other end of the spectrum, yeah, there are a lot of factors that can impact the volatility of real estate.
Sean Aylmer:
Matthew, I learned a lot today about real estate. Thank you very much for talking to FEAR & GREED.
Matthew Strotton:
Oh, my pleasure, Sean. Good to see you again.
Sean Aylmer:
That was Matthew Strotton, executive director, head of real estate at RAM, which is a great supporter of this podcast and runs the RAM Essential Services Property Fund. This is the FEAR & GREED Daily Interview. Remember, this is general information only and you should get professional advice before making investment decisions. Join us every morning for the full episode of FEAR & GREED, Australia’s best business podcast. I’m Sean Aylmer. Have a great day.