Three defensive REITs for a high interest rate/inflation environment

Not all brokers are convinced that the $135bn listed real estate investment trust sector (REIT) is the best place to be within a climate of rising interest rates and inflation.

But with valuations showing sign of having overcorrected – with the sector down -20% year-to-date - Citi suspects some REITs may be beneficiaries of a higher rates cycle.

Citi’s research suggests REITs generated negative absolute returns in only four of the eight rising rates cycles.

The broker’s analysis also suggests that while REITs are more prone to underperforming in the lead-up to the first rates hike, this tends to correct itself in the 60 days after the first increase.

While some REITs are clearly better off within a rising interest rate environment than others Macquarie urges investors not to write the entire sector off.

Despite potential earnings headwind from a higher cost of debt, Macquarie reminds investors that property is for the most part a “real” asset with defensive qualities, especially when leases allow for rents to be raised in line with inflation.

Shift defensively into REITs

After assessing the impact of higher rates on the sector, including the net property income growth, interest costs and asset values with the flow-through impacts to net tangible assets and balance sheets, Macquarie recommends shifting defensively into REITs.

Based on its relative resilience within cyclical downturns, the broker favours increasing exposure to large-cap retail.

Vicinity Centres

Earlier this week, Macquarie upgraded Vicinity Centres (ASX: VCX) to Outperform from Neutral on the back of its strong balance sheet and limited hedging risk.

The broker suspects that with gearing at a conservative 26% and hedging 82%, the group is relatively protected from higher rates, and raised the target is raised to $2.01 from $1.87.

Credit Suisse also believes REITs with lower gearing and higher hedging - like Vicinity - are better insulated from the impacts of rising rates.

The broker has downgraded the REIT’s earnings forecasts -1.7% and -2.5% for FY23 and FY24 respectively and suspects it may look to reduce a $1.8bn undrawn bank debt to lower cost of debt.

Neutral rating and target price of $1.97 are retained.

Dividend yield 6.03%.

Vicinity Centres share price over 12 months.

Scentre REIT

Macquarie has also upgraded Scentre (ASX: SCG) to Neutral from Underperform on valuation grounds.

Despite caution about the balance sheet gearing (39%) and interest cost headwinds over FY22-FY24, with the stock trading on 14x funds from operations (FFO) - and at a -21% discount to NTA – the broker can see value emerging. (Target price $2.85).

Credit Suisse also believes Scentre’s [relatively] lower gearing and higher hedging better insulate the REIT from the impacts of rising rates. The broker retains an Outperform rating while the target price decreases to $3.20 from $3.31.

Ord Minnett also sees emerging value in the REIT sector - due to a stabilisation of long-term bond yields and moderating market cash rate assumptions over the past few weeks – and retains a Buy rating on Scentre (price target $3.20).

The Martin Currie Real Income Fund also favours Scentre as foot traffic recovers in the late pandemic.

The fund manager is impressed by the REIT’s recently demonstrated ability to maintain yields, and notes that strong tenant occupancy trends typically increases the power to push up rents as tenant sales grow.

Dividend yield 5.12%.

Scentre share price over 12 months.

Arena REIT

From an income and cost perspective, amid solid fundamentals, Macquarie also regards Arena REIT (ASX: ARF) as a defensive stock, and earlier this week upgraded the stock to Outperform from Neutral (target $4.61).

The broker believes the REIT’s tenant base continues to benefit from buoyant operating conditions.

Then there’s the early learning sub-sector which is expected to benefit from Labor Government policy to lift the maximum childcare subsidy rate to 90% for families for the first child in care. 

Dividend yield 3.62%.

Arena REIT share price over 12 months.