-Narrower capex margins seen for REITs
-Cap rate compression potential is there
-Preference for earnings growth maintained
-Underperformance but downside limited
By Eva Brocklehurst
There's an emerging dynamic from presentations by management of various Australian real estate investment trusts (REITs), in the wake of earnings season. Goldman Sachs found the return from capital expenditure against asset capitalsation rates is looking lower than in the past.
The cap rate is the ratio of annual income that can be derived against the book value of the asset. A narrowing of the comparison with the cost of investment in expansion and development potentially reduces the profit margin and can increase the development risk. The narrower margin limits upside opportunity, which has typically been available from unrealised development profits on capex works. Generally, it has always been presumed that developing and expanding a property would deliver a healthy yield on the expenditure versus the property cap rate.
Or, put another way, this returns a consistent profit on cost by REITs for the development risk being taken. Re-development has also resulted in a higher yield on incremental investment compared with buying additional properties, where taxes such as stamp duty come into play. Goldman notes there is now a reduced margin for error and demand for specialty stores, in the case of shopping centres, is currently the weakest in a decade.
So, does this mean investment returns in property re-development is more risky? Or are there enough mitigating factors to counter the narrower margin? Goldman analysts suggest several factors could be combining to underpin the narrower margin. These could include owners looking for opportunities to expand on low premiums but still seeing the benefit of upgrading assets. Also, development works could be used as a trigger for shifting the asset cap rate lower by repositioning the property. There could also be limited opportunities for acquisitions.
Looking at the cap rate specifically, Goldman notes cap rate compression is being anticipated in the market. The broker finds limited evidence so far this is actually happening. On the asset side, there are short and medium term headwinds to lifting property values. These include new supply hampering rental growth in the office sector, high occupancy and low margins for tenants in the retail sector, and lower barriers to entry in the industrial sector. So, the risk of valuation upside from potential lower cap rates could be offset by lower rent in the analyst's opinion. Moreover, the market does not appear to be actually pricing in cap rate compression to stocks yet. Goldman suspects the market may be, at this stage, differentiating between REITs with earnings growth potential and those with short-term earnings headwinds.
Morgan Stanley has emerged from discussions with REITs and believes the outlook for cap rate compression is a bit mixed. What can be generally said, in keeping with Goldman's view, is there's little expectation for downside risk to asset values. Whilst it was generally acknowledged that asset values were well supported, the point is whether a moderating rental outlook across office and industrial markets would offset any cap rate compression with regard to driving asset values up. In the end, the broker suspects the potential for cap rate compression is higher for office and industrial than retail REITs, purely from the point of higher average starting yields in each sector. Whilst risk profiles do differ between office, industrial and retail, Morgan Stanley expects greater appetite for assets and transaction activity will translate into the office sector seeing the bulk of cap rate compression.
UBS finds fundamentals have been sufficiently rebased and compression is around the corner. The broker believes the appetite for yield along with transactional evidence illustrates cap rate compression is likely to occur this year. The broker expects 10-30 basis points of cap rate compression across prime office property as well as net asset appreciation over the next 12-18 months. Nevertheless, earnings upside from acquisitions enables the broker to be most favourably disposed to the office REITs. The broker's pick across the office REITs is Dexus Property ((DXS)), given its quality of income, earnings growth and potential earnings upside.
On the shopping centre side of things UBS retains a preference for Westfield Retail ((WRT)), reflecting a higher quality portfolio. Whilst cap rates remain supportive of existing valuations in the higher quality regional shopping centres, the broker is cautious about a sharper deterioration in comparable net operating income. Income and rental growth is expected to remain soft as sales struggle to grow, particularly across specialty apparel.
Morgan Stanley finds attractive dividend yields from the REIT sector had been a major supportive factor in performances in the past 18-24 months. But the yield premium investors get from REITs against the ASX is now at an all time low. With many REITs now trading around the level of net tangible assets, the broker believes the focus needs to be on earnings growth potential, and thus stock preferences favour REITs that can supplement rental income with active earnings streams (such as funds management or development).
The wide spread of Australian commercial property cap rates to the 10-year bond rate also has analysts' attention. Market participants (including REITs) and some REIT investors cite the spread between Australian commercial property cap rates and the 10-year bond rate as a potential driver of cap rate compression within Australia's commercial property markets, according to Goldman. Now, this could lead to a valuation uplift at the direct property level. There may be some merit here, particularly in the case of a good property, but the analysts caution against taking this too far across the property sector.
Macquarie has noted that, for the first time since mid 2011, the spread between the average REIT dividend yield and 10-year Australian government bond yields is back at the 10-year average. Rising bond yields have historically resulted in REIT underperformance against the broader ASX market. Macquarie's equity strategists are becoming more positive on the growth outlook. These factors will likely result in REIT underperformance in the near term.
Nevertheless, there's underperformance and underperformance. Macquarie believes the downside is limited. Several REITs should see a modest acceleration of earnings growth into FY14/15 as lower debt costs and corporate cost savings support underlying property fundamentals. For Macquarie, CFS Retail ((CFX)), Charter Hall ((CHC)), Investa Office ((IOF)), DXS and GPT ((GPT)) are going higher and these are the preferred exposures. Least preferred are Westfield ((WDC)) and Stockland ((SGP)). WDC is trading on the highest PE multiple with limited near term growth and offering the lowest free cash flow and dividend yields in the sector. In terms of SGP, the broker expects medium term residential sales targets are likely to be downgraded at the third quarter update in May.
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