Feature Stories | Sep 29 2016
This story was first published for subscribers on September 12 and is now open for general readership.
For those wanting to partake in A-REIT investment brokers take a look at where the buying opportunities lie, given recent under performance of the sector.
-Increasingly expensive relative to equities but distribution yield spread to long bonds still appeals
-Residential valuations less compelling and cycle may be close to the peak
-Office portfolios considered well positioned in current environment
-Slowing retail sales a headwind for that sub sector
By Eva Brocklehurst
After the reporting season, the performance of Australian Real Estate Investment Trusts (A-REITs) is likely to be driven by macro factors and Morgan Stanley considers there are none more important than the trajectory of US interest rates, as relative performance is highly correlated. Expectations for a lift in US rates have driven the underperformance of the sector recently. Pull-backs in February and late March proved to be buying opportunities and the broker mulls whether the current situation provides another chance.
While the sector may struggle against rising rate expectations, for those wanting to partake in sector investment Morgan Stanley favours stocks with a growth bias, such as Goodman Group ((GMG)), Lend Lease ((LLC)), Stockland ((SGP)), and Westfield ((WFD)), preferring these in relative terms to Scentre Group ((SCG)), Mirvac ((MGR)) and Charter Hall Group ((CHC)).
Office-exposed A-REITs are preferred over retail and the active managers of assets over passive. Decreasing price momentum and downgrades to distributions for several passive A-REITs, particularly those with lower-quality assets, could lead to further under performance, Morgan Stanley believes.
Specifically, while Westfield is testing investor patience, the broker continues to believe 2016 will represent a trough in the earnings cycle and growth can be driven by US$1.2bn in 2017 development completions. Morgan Stanley suspects any overweight positioning in Scentre Group is at risk. Goodman Group's development pipeline also allows it to be a net seller of assets during cyclical peaks.
Morgan Stanley retains an Attractive industry view but observes the risks are in a rising bond yields, positive earnings momentum for industrial stocks and material tightening in credit conditions. In residential sub-sectors there is still a sweet spot across the board, but the broker prefers Stockland to Mirvac because of the clarity in the outlook,with a record level of net deposits.
In residential segments, Goldman Sachs believes FY17 settlement risk is overstated and, while volumes and margins are strong, the house price outlook is more mixed and construction approvals are flattening. This suggests to the broker that the cycle is close to a peak and pre-sales growth is likely to slow.
UBS, too, considers residential valuations are less compelling now, but Mirvac appears the cheapest in terms of the implied value for its development business. Mirvac is the broker's preferred of the large caps, with its NSW and office exposure and implied multiples for development business.
UBS continues to believe Australian property is attractive on a global basis, as its yields versus bonds are wider than average compared with other developed markets. Investors may have increased their exposure to A-REITs over the past nine months, but the broker does not consider the sector a crowded overweight realm.
The broker is surprised by the robust outlook for the office market and envisages 11% and 19% upside to estimates for Dexus Property ((DXS)) and Investa Office ((IOF)), respectively, over the medium term. Outside of the A and B grade Sydney assets, Goldman Sachs expects office segment operating income growth will be modest.
In terms of spot bond rates, A-REITs appears reasonably priced on most traditional valuation measures, Credit Suisse suggests. Post a reporting season that was underwhelming, the broker retains just three large cap Outperform ratings: Scentre Group, Westfield and Lend Lease. Credit Suisse observes the gap between high and low productivity assets was evident in the results, with sales for GPT Group ((GPT)), Mirvac and Scentre Group outperforming peers.
The broker continues to view Investa Office and Mirvac's office portfolios as best positioned in the current environment. Credit Suisse also finds the earnings quality questionable generally, with office A-REITs the largest beneficiaries of the expiry of incentives on leases being below that of replacement leases.
On of the more interesting items in the reports was the announcement by BWP Trust ((BWP)), that Bunnings will vacate up to seven of the 81 properties in the trust to move to newly acquired stores and developments.
Credit Suisse has argued that over the long term, tighter cap rates – the ratio of asset value to producing income — lead to lower rents for generic real estate as developers undercut existing rents. This is now playing out in those asset classes with short development time frames. Credit Suisse notes the only asset class where the replacement cost maths does not hold up is in high quality malls.
In light of the strong FY16 performance, the sector looks increasingly expensive to the broker, relative to Australian equities. The sector's prospective distribution yield of 4.6% compares to an historical average of 6.4% but in the current environment a 270 basis point distribution yield spread to long bonds remains appealing, for the near term at least.
The highlight of profit season for Ord Minnett was the strength in residential, with both Stockland and Mirvac reporting higher sales and expanding margins. The broker, too, notes Sydney office incentives have declined and monetising this in terms of better income growth is challenging.
All five major retail landlords reported slowing specialty sales growth. Balance sheets are in good shape, gearing is low and there is plenty of investment capacity but acquisitions remain very competitive, Ord Minnett observes, so deploying capacity may prove challenging and begin to weigh on earnings growth.
The season highlighted a stark contrast in earnings/cash flow growth, with developers and fund managers typically growing the fastest, and the passive rent collectors missing out, Macquarie observes. Non-core asset sale programs may be okay in the longer term for Vicinity Centres ((VCX)) and Charter Hall Retail ((CQR)) but modest net operating income growth combined with more static debt costs and dilutive asset sales can be a hindrance.
The broker observes the backdrop is strong for fund managers such as Goodman and Charter Hall, while Lend Lease has an attractive profile at a reasonable valuation. The retail bond proxies, such as Vicinity Centres and Scentre Group, are expensive in Macquarie's opinion, offering limited upside risk to earnings. Aventus Retail Property ((AVN)) is a preference in terms of its tenant base. Westfield is considered expensive and translating lost earnings from dilutive asset sales into accretive developments will take time, in the broker's view.
UBS has moderated its outlook for the retail A-REITs, suspecting the global trend of retailers swapping large formats for small at lower rents is only starting to occur and additional capex on revamped precincts for entertainment and lifestyle could put pressure on cash flow growth.
Goldman Sachs agrees slowing retail sales are a headwind for the sub-sector. Passive A-REITs under its coverage have a skew to ownership of retail assets. The broker upgrades Charter Hall Retail to Buy, believing it provides good value, and that the reaction following the flat guidance from the FY16 results is overdone. The broker considers the company's flat guidance conservative and primarily based on potential earnings dilution from asset sales. Goldman expects the valuation discount will narrow as management executes on its strategy.
Charter Hall is downgraded to Sell as it appears fully priced. The broker acknowledges Charter Hall has achieved scale in funds under management but expects its full valuation multiple will revert to reflect lower earnings growth potential.
Goldman upgrades GPT to Neutral on valuation grounds as it offers investors access to a portfolio of some of Australia's premier retail, office and logistics assets. While the broker does not envisage a material improvement in the supply demand dynamics for Sydney and Melbourne office, and retail may slow, the company's development pipeline offers upside potential.
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