The properties that stand to benefit from ongoing rate changes

While property is always a popular BBQ conversation, you could say it’s been a pressing concern over the past year (after the increasing cost of hosting said BBQ). As the RBA launched a sharp series of rate hikes in May last year, market consensus expected property to fall in value, especially residential.

Prices for residential property fell around 9% in 2022 according to CoreLogic, with the bottom for prices around the start of 2023. Since then, we’ve seen six consecutive months of growth. While residential property has benefitted from low supply and the return of migration, is it the same story across the sector?

Short answer, no.

According to Morgan Stanley, commercial property values and transactions have been challenged and are still yet to recover to pre-covid levels.

“The higher interest rates has taken a toll on earnings, negating the post-covid bounce-back in rent and other income items,” said equity analysts Simon Chan and Lauren A Berry.

What has happened in commercial property?

The impact of interest rates is not simple when it comes to commercial property. Companies in this space are exposed to a range of factors in the ultimate cost of their debt, rather than simply the official interest rate itself.

These include factors like the bank bill swap rates, hedge rates, hedge to fixed rates, hedged/fixed rate profile, along with duration of debt instruments.

The sharp increase in rates over the past year has meant a drop off in transactions and valuations. Earnings in rent collecting properties have been flat to down. Office properties have been the worst hit in valuations. This perhaps is less surprising given the return-to-office hasn’t been as pronounced as most companies would have hoped and office properties are having to reconfigure and rethink the use of space to entice workers in.

Source: Morgan Stanley research 18 September 2023

It's not all bad news. Morgan Stanley anticipates revenue to recover in FY24 to around 98% of pre-Covid levels, but earnings expectations are still around 9% below.

Where to invest going forward

Morgan Stanley have tipped one more rate rise, bringing the terminal cash rate to 4.35% in November and the chance of some cuts in 2024, but if we’ve learnt nothing from the old “no rate rises until 2024”, it’s that anything can change.

Morgan Stanley argues that the market has underestimated the impact of higher rates on property, and equally is likely to underestimate the impact of any falls in rates in the coming year.

In theory, REITs should benefit from rate declines, but Morgan Stanley argues that this is dependent on gearing and how interest rate books have been managed.

To that end, it’s investigated who stands to benefit from further hikes of up to 50bps and which would benefit from cuts of 100 bps.

In the event of rate cuts, it tips the following to benefit most with 7-12% uplifts: 

• Charter Hall Long Wale REIT (ASX: CLW)

• Healthco Healthcare and Wellness REIT (ASX: HCW)

• Centuria Office REIT (ASX: COF)

• Centuria Industrial REIT (ASX: CIP)

• Charter Hall Retail REIT (ASX: CQR)

The reason for this view is that these companies have the lowest hedge ratios and therefore would have full exposure to (and therefore the benefit of) a cheaper cost of debt.

By contrast, those companies to benefit from a rate hike includes: 

• Stockland (ASX: SGP)

• National Storage REIT (ASX: NSR)

• Dexus (ASX: DXS)

• Vicinity Centres (ASX: VCX)

• Arena REIT (ASX: ARF)

These have more than 60% of their current borrowings hedged, meaning the least exposure to upwards movements in rates.

With Morgan Stanley tipping a 25bp hike by the end of the year, it’s worth keeping these thoughts in mind. Those companies with the highest levels of debt hedged will be the least impacted – though will not benefit as much should rates fall. Hedge duration also matters – ideally if you are anticipating cuts in FY24, you would hope to see short duration to then benefit from cheaper cost of debt.

This article was first published on Livewire Markets on Wednesday, 20 September 2023.