A-REITs Stronger, Defensive And Attractive

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– Analysis shows A-REIT earnings are defensive
– Balance sheets for A-REITs have strengthened
– Sector offers value relative to NTA

By Chris Shaw

At current share price levels, reports BA-ML, A-REITs on the ASX offer 31.5% in average implied total return, with an average discount to price objectives of 17.7% ex Westfield Group ((WDC)). 

Despite overall sector outperformance last week, some Australian REITs have underperformed significantly in recent weeks, so Citi has attempted to assess how defensive are earnings in the sector. The analysis involves determining the proportion of earnings that can be classed as low risk.

For Citi, net operating income, which is net income from rental streams, is relatively low risk. This form of income is estimated to generate 86% of EBIT (earnings before interest and tax) in the sector and more than 95% of EBIT for nine of the 16 stocks in the REIT index.

Long-term leases make this form of income more stable, so improving earnings visibility, while Citi notes the major risks are changes in occupancy and rents and movements in net operating income margins.

Development earnings are higher risk as they can rise or fall depending on other variables, but Citi estimates this contributes only 8% to sector EBIT and so is a somewhat minor contributor. Funds management earnings can be either high or low risk depending in part on how they are calculated, as fees can range from base management to performance fees. 

While real estate fund managers have tended to outperform the sector and the broader market in upswings, Citi notes this earnings stream only accounts for 6% of sector EBIT.

With respect to interest, Citi notes this can add a form of leverage for REITs and so add to earnings volatility. While leverage for REITs is higher than for other large capitalisation corporates, Citi notes it remains well down from peak levels.

As net interest represents about 21% of sector EBIT at present, Citi notes earnings before tax is currently about 27% more variable than EBIT. In contrast, tax is a small line item in REIT income, as tax is generally passed through to unit holders.

Adding all this up, Citi suggests REIT sector earnings in general are now quite low risk, making the sector a relatively defensive one from an earnings perspective. 

The stocks offering higher earnings risk are typically companies generating a significant contribution to earnings from development operations. Citi suggests the likes of Stockland ((SGP)), Mirvac ((MGR)), Goodman Group ((GMG)) and Australand ((ALZ)) all fit into this category.

In the sector Citi rates Australand, BWP Trust ((BWP)), CFS Retail ((CFX)), Charter Hall Group ((CHC)), Dexus Property ((DXS)), Goodman Group, Stockland, Westfield Group and Westfield Retail ((WRT)) as Buy.

Hold ratings are ascribed to Abacus Property ((ABP)), Charter Hall Office ((CQO)), Charter Hall Retail ((CQR)), Commonwealth Property Office ((CPA)), GPT ((GPT)), Investa Office ((IOF)), Mirvac and Valad Property ((VPG)).

Leading into earnings results for the sector this month, Deutsche Bank gives Charter Hall Group, Charter Hall Retail, Mirvac and Stockland Buy ratings, while CFS Retail, Cromwell Property ((CMW)), Commonwealth Property Office, Charter Hall Office, Dexus and GPT score Hold ratings. All four have been upgraded from Sell ratings to reflect recent share price moves, while Tishman Speyer ((TSO)) is also rated as a Hold.

Deutsche suggests the generally defensive earnings streams and strong balance sheets of Australian REITs should deliver outperformance against the broader market in the current environment, though there is scope for earnings commentary through the sector to highlight increasing uncertainty with respect to tenant demand in key office markets.

In Deutsche's view retail sector sales and commentary are both likely to be better than implied by current share prices, as while specialty sales growth is slowing it appears to have remained positive. For the office sector there is not likely to be any meaningful reduction in incentives, meaning any result commentary with respect to commercial tenant demand could be cautious.

Given its residential operations, Deutsche expects Stockland to offer subdued commentary given ongoing weakness in the Queensland residential market and a normalising of demand in Victoria. The stock is priced for worse in Deutsche's view, which supports the broker's Buy rating.

Overall, Deutsche points out as companies in the sector have already provided some form of earnings guidance for FY11, the market's focus is likely to be on the composition and quality of earnings and any outlook commentary offered by management.

As unit prices have fallen JP Morgan's focus has been on net tangible assets (NTA) across the Australian REIT sector, as well as the funding mix, liquidity position and gearing levels of the various companies.

In general, JP Morgan found REIT balance sheets are fundamentally stronger now than during the GFC, while lending liquidity has been good and debt terms to maturity across the sector have improved a lot over the past couple of years. 

The average term to maturity across the sector now stands at 3.5 years, so JP Morgan suggests debt duration is no longer the risk it has been in the past. One emerging theme is the re-emergence of a capital partnering business model for funding capex, with Westfield Retail a good example of this trend.

Given $12 billion in Australian commercial real estate transactions over the past year, JP Morgan suggests NTA is now well supported by recent market deals. The sector, excluding Westfield Group and Goodman Group, closed last week at a 24% discount to NTA.

Post its analysis the key picks of JP Morgan have not changed. Overweight recommendations remain on Westfield Group, GPT, Stockland, Mirvac and Westfield Retail. 

The Productivity Commission in Australia has released a final review into aged care and nursing homes, BA-ML noting the target is an improved regulatory framework for residents and care/accommodation providers and a lesser future burden on taxpayers.

BA-ML suggests the report has some indirect positive effects for the retirement village sector, where exposure is most easily gained through Lend Lease ((LLC)), Stockland and FKP Property ((FKP)).

One key emphasis of the report is to delay for as long as possible any move into acute government supported aged care, with a recommendation for people to receive government supported aged care services irrespective of existing living arrangements.

BA-ML suggests by encouraging people to remain out of aged care facilities as long as possible there is scope for retirement village resident tenure to increase. While this would suggest lower accrual fees, a likely offset is increased demand for retirement village accommodation.

Aged care providers would have greater pricing control according to the recommendations, while BA-ML notes there would also be scope for additional charges for a range of services within facilities. In terms of pecking order among the aged care providers, BA-ML favours FKP Property over Stockland, followed by Lend Lease.

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