Retail REITs face 'rough ride and low leverage is crucial' - Kempen

Retail REITs are in for a rough ride, especially those with higher financial leverage and inadequate dividend coverage, experts at investment manager Kempen warned this week.

The firm, which has just lowered its 2020 net operating income growth assumption for the entire listed real estate industry by 5-15%, said that retail REITs with a lean balance sheet have a much higher chance of weathering the crisis.

‘Clearly, a difficult environment for retail REITs has just got tougher,’ said Anna Niegowska, senior portfolio manager of KCM’s Kempen Global Property Fund. ‘The virus is having a major impact on mall traffic and tenant sales of discretionary items, with few international tourists and abundant fears expressed by local consumers of going to a public gathering place. As more countries are moving towards an ‘Italian’-scenario which includes shutting down bars and non-food stores, short term revenue growth will be affected.’

He added: ‘A prolonged impact of the virus could further lead to factories getting closed, workers being furloughed, and consumers ceasing to spend. As production has slowed down, or even stalled, supply chains have become interrupted, leaving retailers with less stock in hand or with high margin pressure if shifting production temporarily away from afflicted areas is necessary. Factory closures, particularly those in China, could therefore accelerate bankruptcies from already struggling retailers, leaving both short- and long-term NOI growth under pressure.’

Low debt is crucial

Having low leverage, in the form of low loan-to-value (LTV) and low debt/NOI, is absolutely key under current conditions. Any company that is now forced to reduce debt for example through selling assets or raising equity in the market faces risk, the investment manager warned.

While tough on everyone, the current situation is also expected to give way to opportunities to buy good stock at a bargain, as markets tend to sell off indiscriminately driven by (passive) investors facing redemptions. ‘It is fascinating to see how two companies, with one operating on very low leverage, and one operating on very high leverage see similar share prices drops. This creates opportunities for active investors who identify such mispricings,’ Kempen’s Niegowska said.

Other sectors

Looking across the different real estate sectors in the industry, more operationally geared real estate segments like hotels, senior housing, and leisure are expected to be worst hit by the epidemic and experience the largest fall in values.

Hotels in particular feel the COVID-19 impact in real time when travel restrictions are imposed and conferences get cancelled. ‘It is therefore no surprise that hotel REITs have been the worst performers in the past weeks given that the sector will see an unexpected but certain hit to operating income,’ Kempen noted.

Performance also appears to be materially worse in major cities, and this is especially bad news for hotel REITs which tend to own properties in key gateway markets which are hit by travel bans.

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