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This is the latest ASX 200 sector to be hit by downgrades

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The earnings downgrade cycle may only just be starting and this ASX 200 sector is the latest to get the chop from a leading broker.

While big hikes in interest rates and recession fears have roiled the S&P/ASX 200 Index (ASX: XJO), ASX real estate shares are likely to feel an earnings squeeze over the coming months, according to Morgan Stanley.

Some might be surprised by the forecast. After all, real estate is meant to be one of the safer places to park capital when growth slows and inflation rises.

This is because their earnings tend to be protected by relatively long leases and rents often have an inflation adjustment mechanism.

But these aren’t enough to offset the rising cost of finance for several ASX 200 real estate shares, according to Morgan Stanley.

Financial de-engineering

ASX 200 real estate shares use financial leverage to maximise returns. This entails the creative use of debt and hedging contracts.

Their ability to generate returns and dividends for shareholders is getting constrained. The cost of three-year base rate hedges have jumped to an average of around 3% since March 2022. Morgan Stanley noted this used to cost 0.75% in the prior 12 months.

Moreover, the floating base rate, or Bank Bill Swap Rate (BBSW), currently stands around 1.8%. This reference rate was 0.1% in the preceding two years.

While many ASX 200 real estate shares have locked in their debt for the next six to 12 months, this only covers around 60% to 70% of their borrowings.

Further, rates are expected to stay elevated for the medium to longer term. This means these companies could face a refinancing headache over the coming year.

Another downgrade headwind for these ASX 200 shares

If this isn’t enough to rattle the sector, cap rates are likely to rise, Morgan Stanley warned. Property values drop as cap rates rise, and vice versa.

The real estate investment trust (REIT) cap rate spread above the 10-year Australian government bond yield is now circa 120 basis points. That’s the tightest in the last decade.

As a result of these headwinds, Morgan Stanley downgraded its recommendations on GPT Group (ASX: GPT) and National Storage REIT (ASX: NSR) to “underperform”.

The GPT share price is trading 4.68% lower at $4.375 while the National Storage share price is down 5.6% to $2.19 at the time of writing.

Other ASX real estate shares in the firing line

These aren’t the only real estate shares that got a ratings cut. The broker also downgraded Charter Hall Long WALE REIT (ASX: CLW), Healthco Healthcare and Wellness Reit (ASX: HCW), and Centuria Industrial Reit (ASX: CIP) to “equal-weight”. The three companies have shed 6.9%, 7.82%, and 6.11% respectively at the time of writing.

Morgan Stanley explained:

These five stocks have endured the largest downward EPS [earnings per share] adjustments in our modelling, largely because of their low existing cost of debt, and also relatively low/short rate hedge profile.

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