Australia | Sep 04 2012
– A-REIT reporting season was solid
– Earnings resilience remains a feature
– Brokers review themes to emerge
– Preferred sector exposures updated
By Chris Shaw
For the week ending August 31st, Australian REITs (real estate investment trusts) outperformed the broader market by delivering flat returns, this against a 0.5% fall for the market overall. Helping the outperformance was a solid profit reporting season for the sector, BA Merrill Lynch noting on average A-REIT earnings were 0.6% better than had been forecast. Earnings showed overall growth of 2.7% relative to FY11.
Earnings resilience was also a feature of A-REIT reporting season, as BA-ML points out no company reported earnings more than 1.0% below what the broker had forecast despite challenging operating conditions.
This resilience should continue, as despite lowering forecasts in earnings per share (EPS) terms by 0.5% post the reporting season, BA-ML continues to forecast 3.1% earnings growth in FY13. Dividend growth should be even better at a forecast 4.1% for the coming year.
Having reviewed reporting season for A-REITs, key sectoral themes to emerge in the view of JP Morgan are CEO changes, inconsistent earnings definitions, an increase in payout ratios, some hedge restructuring, a decline in debt costs and a focus on cost cutting.
Both Mirvac ((MGR)) and Stockland ((SGP)) announced surprising changes in CEO, while the likes of FKP Property ((FKP)) and Aspen Group ((APZ)) are also undergoing some management changes. Some companies in the sector are moving away from EPS as a measure of earnings as evidenced in the latest reports, while JP Morgan notes a number of A-REITs are taking advantage of low interest rates to re-set out-of-the-money interest rate hedges.
Lower interest rates also meant debt costs for many A-REITs were lower than in FY11, JP Morgan noting this has been a slight positive for margins across the sector. Cost cutting has also helped in this regard, with management teams looking for ways to boost returns in what remains a lower growth environment.
In terms of vacancy trends in FY12, BA-ML notes retail vacancies showed no increase, though more marginal developments are being deferred at present. Office portfolios delivered good results with respect to declines in vacancies, which helped deliver solid net operating income growth.
BA-ML also notes property cap rates are showing some sign of improvement given recent reductions in bond and risk-free rates, though valuers continue to remain conservative. BA-ML's numbers suggest the average net tangible asset of the sector improved by 0.2% in year-on-year terms.
One trend of interest to JP Morgan is that over the past 18 months A-REITs have been in defensive mode, being net sellers of assets and using the proceeds to buyback stock and strengthen group balance sheets. But with discounts to net tangible assets now closing this buyback activity has slowed, leading JP Morgan to suggest the market may see A-REITs become more aggressive in terms of reactivating development pipelines and becoming net acquirers of assets.
This trend has just started to emerge, as JP Morgan estimates the total volume of domestic property transactions in August was $770 million. For the past 12 months there were a total of 107 major transactions, totalling $12.6 billion.
On a stock specific basis JP Morgan suggests the major outperformers across A-REIT reporting season were Charter Hall ((CHC)), Goodman Group ((GMG)), Australand ((ALZ)) and Carindale Property ((CDP)), while the major underperformers were FKP, Mirvac, Stockland and Dexus ((DXS)).
For BA-ML it was GPT Group ((GPT)) that delivered the standout result, with cost and interest savings driving EPS upgrades of around 3% post release. The most disappointing result among large caps came from Stockland, BA-ML noting guidance for FY13 was soft as the company deals with a transition year and a change in senior management.
FKP was the major disappointment among small caps for BA-ML, the result including a significant impairment charge and a capital raising to repay debt. The latter in particular surprised as it had been expected cash flows would have been enough to avoid the need for an equity raising.
Going forward, the major changes BA-ML have factored into its models are a further delay in a recovery in residential markets, reduced debt costs where hedges have been broken and some cuts in corporate cost expectations. The broker notes the timing of capital management moves continues to impact on earnings, while strategy changes from new management are also seen as potentially impacting on forecasts.
BA-ML expects a switch from capital management to a focus on acquisitions given lower costs of capital, while fund management models are likely to see an increase in inflows as investors chase the yields available in the property market. Developments should continue to be impacted by a lack of confidence in both tenants and landlords and the difficulty of obtaining pre-commitments.
Preferred picks in the A-REIT sector for BA-ML are Westfield Group ((WDC)) and Mirvac among the large caps, along with Charter Hall and Centro Retail ((CRF)) in the mid-caps. The focus for BA-ML is stocks offering earnings growth and potential for return on equity improvement, along with potential catalysts from restructuring and strategy changes.
Morgan Stanley's conclusion post the reporting reason for A-REITs is that the sector continues to offer a defensive exposure, but valuations are less compelling given solid outperformance year-to-date. As well, there is potential for the next phase of growth to lift risk profiles. This sees the broker downgrade its industry view to In-Line.
At current levels the sector is now trading at a 16% premium to the market, this while like-for-like momentum is now slowing and the risks to vacancies and incentives are increasing. This leads Morgan Stanley to suggest the A-REIT sector could underperform if there is a faster than expected recovery in wider market earnings, while sector outperformance could come from significant downgrades for the broader market or further cuts in official interest rates.
In Morgan Stanley's view outperformance will be driven by A-REITs able to deliver growth from cost savings, portfolio increases, asset recycling, active income streams and in some cases entry into new markets.
As part of its sector review Morgan Stanley has revised a number of stock ratings, upgrading Mirvac and Stockland to Overweight from Underweight to reflect a more positive outlook for residential developers. While not turning outright bullish on the sector, the broker does suggest development earnings have found a base and subsequent above average earnings growth and attractive yields will support both stocks.
At the same time Morgan Stanley has downgraded ratings on Investa Office ((IOF)), Charter Hall Retail ((CQR)) and Commonwealth Property Office ((CPA)) to Underweight from Overweight. In each case the downgrade is stock rather than industry specific and reflects less valuation upside and a lack of catalysts to drive above-average earnings growth.
Overall, Morgan Stanley rates Goodman Group, Stockland, Westfield Group, Dexus and Mirvac as Overweight, while GPT, Investa Office, Westfield Retail ((WRT)), Charter Hall Retail, Commonwealth Property Office, CFS Retail Property ((CFX)) and Australand are rated as Underweight.
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