The fact that Australians have a love affair with property is not news to anyone. Turn on your TV and you will soon see an ad promoting yet another home renovation show.
Even the regular news bulletins get in on the act. Auction clearance rates are reported each weekend as though it a sport. Each month we can expect an update on how property prices are tracking.
Because of that, there’s little surprise that property is one of the more popular income generating investments on the ASX. You’ll know them as Real Estate Investment Trusts (REITs).
REITs give investors the opportunity to invest in a range of properties through a single holding. By buying a unit in a REIT, an investor can invest in office blocks, shopping malls, industrial sites, supermarkets and warehouses.
Plus, there are ETFs which enable you to invest in a broad group of REITs as well.
Rather than investing in commercial property themselves — something that could cost many millions — investors can invest as little or as much as they like in a REIT.
And because the properties in a REIT have a manager, the investor doesn’t have to deal with the day to day hassles that comes with owning property. Things like maintenance and negotiating with tenants over leases.
It’s all about income flow
One of the other attractions of REITs is their regular and reliable income flow. Because tenants usually sign up for fixed periods, a REIT’s cash flow is typically more predictable than a regular business.
Often the lease will also include set rental increases. Again, that’s something that helps predict future income flow.
That’s why you’ll often see REITs described as being like a bond. That is, a bond ‘substitute’ or ‘proxy’. That’s because bonds also have a known income stream.
And it’s not just REITs. Infrastructure assets like toll roads also have similar characteristics.
Because REITs are similar to bonds, they attract similar types of investors. That is, those investing for yield. While capital appreciation is always welcome, it’s not their primary aim.
Just as bonds are sensitive to interest rates, so too are REITs.
If one bond pays more interest than another, an investor is likely to pay more to buy it. Similarly, an investor will be prepared to pay less for a bond that pays less interest.
If a REIT pays a higher yield than a bond, then these same investors will allocate more of their funds into REITs.
However, the opposite also occurs. As rates on bonds increase, some of this money heads back into bonds.
Watching the Fed
In March this year, the US Federal Reserve raised rates for the sixth time since 2015. The Fed uses a target band — the current rate is 1.5–1.75%. It marked the first time in around 18 years that US rates are higher than those in Australia.
The market has penciled in another two rises in the US this year, with the next expected in June. There are some who believe there could potentially be three. Either way, the US Fed has signaled its intention to raise rates further through 2019 and into 2020.
At first glance, you would expect this to pull more money out of REITs.
Although, since that last rate rise in the US in March, some of our biggest REITs have actually started to rally. REITs like Scentre Group [ASX:SCG] and GPT Group [ASX:GPT] are both up around 10% since April.
Perhaps that’s not a big move compared to some of the smaller companies on the ASX. In Scentre Group, though, we are talking a market-cap over $22 billion. With GPT, it’s over $9 billion.
In part, some of this rally has to do with the takeover of Westfield Group [ASX:WFD]. Last week, shareholders approved the $30 billion deal with French suitor Unibail-Rodamco. Investors in other REITs might be hoping for the same.
The recent rally in REITs, though, also highlights something else. And again, it comes back to yield. Although bond rates are increasing, REITs still pay a handy yield. If a REIT has a yield of 7%, and a bond 3%, there is still a big difference between the two.
It is not so much that this higher yield puts a floor under the value of a REIT. It does, however, mean that there is a constant relationship between the two. If rate increases stall, or once again fall, more of this yield money will flow back into REITs.
It comes down to timing
Plus, there is another thing to consider. And it all has to do with timing. What the Fed will want to avoid is raising US rates too quickly compared to other central banks. The other big hitters, that’s Europe and Japan, continue with their low interest rate environments.
If the US keeps raising rates, and nobody else does, its currency will soar. That might be good for US companies looking to invest offshore. However, it could really put a dent in its export activities — something that will harm its economy.
That’s why, although the Fed has signaled it will continue to raise rates, it still needs to be measured in its approach. It can‘t get too out of sync with all the other central banks without causing some headaches for itself.
Investors in REITs still need to keep a close eye on what the Fed does in the US. But also remember that it’s an ongoing battle of yield (and currency).
Many REITs have long-term rental increases locked into their tenant’s agreements. That not only helps build their yield, but also brings buyers into REITs if this yield gap grows too wide over those available on bonds.
All the best,
Editor, Total Income