Investors in REITs at risk of significant capital losses: Morningstar

Australian commercial property is overvalued and investors in real estate investment trusts are at risk of significant capital losses when interest rates and bond yields rise, an analysis by investment researcher Morningstar has concluded.

Low interest rates have lead investors to divert capital from bonds to higher yielding property, which has driven asset values higher.

Commercial property values could drop by as much as 10 to 15% over a year when interest rates and bond yields rise again, making fixed income more attractive to investors, Morningstar suggested in a report on the Australian real estate investment trust (A-REIT) sector.

“It’s quite conceivable that when interest rates rise, property values could fall in orders of that magnitude,” Morningstar senior equity analyst Tony Sherlock told Property Observer.

The outlook for rental income from commercial properties was stable but income growth would be more than offset by the loss in asset values, he added.

Central banks have indicated that interest rates will stay low for a sustained period, although bond yields can increase ahead of any rise in official cash rates.

“From current levels, interest rates are going to eventually rise and when they do rise they are probably going to rise a bit faster than people expect,” Sherlock said.

Property values would respond fairly quickly to rising interest rates but A-REIT share prices could fall even more rapidly, he said.

A-REIT prices fell 10% over three weeks in May 2013 after yields on 10-year US treasuries increased by 10% when US Federal Reserve Chairman Ben Bernanke flagged a possible tapering of US quantitative easing.

The risk of investing in property through A-REITs was now “arguably greater” than usual because most were trading at a premium to the book value of their assets, “some by as much as 30%”, the Morningstar report noted.

Defensive A-REITS with low-risk tenants, such as BWP Trust, which owns Bunnings Warehouse properties, and ALE Property Group, which invests in pubs, were trading at the biggest premiums to book value and would be exposed to the largest share price falls, it said.

Sherlock said A-REIT prices had already started to fall due to rising bond yields and sales by offshore investors who were beginning to leave the market as the Australian dollar weakened. In the month to 18 September, the S&P/ASX 200 A-REIT index dropped 3.74%.

This article originally appeared on Property Observer.