Opportunity Knocks In Retail A-REITs

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Several factors are behind the underperformance of A-REITs but brokers are discounting many of them and suggest the sector presents some opportunities.

-Retail A-REITs may offer better value amid limited downside
-Vicinity Centres and Scentre Group considered oversold
-Australian landlords seen well positioned to cope with increasing online sales
 

By Eva Brocklehurst

On a macro level the recent sell-off has created some opportunities in the A-REIT sector. Macquarie reinstates an outperform stance, observing A-REITs sold off materially as global increases in bond yields were factored in.

The broker observes the distribution yield spread to bonds remains attractive at 270 basis points and, assuming this spread normalises to the long-term average of 195 basis points by keeping the bond yield static, this will equate to around a 20% top-down total shareholder return.

Macquarie cannot envisage how the US Federal Reserve will continue to tighten rates without dislocating financial markets and at the same time maintain a 2.3% long-term US bond yield forecast. The broker expects the sector's performance will remain correlated with changes in the 10-year bond.

Retail

The perceived structural and cyclical factors which have caused the retail A-REITs to underperform in the year to date include the pending arrival of Amazon, slowing retail sales and the high household leverage that affects discretionary expenditure.

CLSA argues that, while the pull-back across the the sector makes office names more attractive, the retail A-REITs offer much better value amid limited downside. While office will have stronger reversionary rental growth than retail over the next three years this appears to be priced in, in the broker's view.

There is less volatility in earnings from the likes of retail A-REITs such as Scentre Group ((SCG)) and Vicinity Centres ((VCX)) and distribution yields are also more sustainable. CLSA's preferred exposure is Scentre Group, suggesting it remains the highest quality retail A-REIT, offering a maintainable 5.3% distribution yield and growth rate of 4.2% over two years for earnings per share.

Meanwhile, Vicinity Centres has done a good job in the broker's opinion in realising around $50m of synergies and divesting around $1.5bn in assets post its merger. Vicinity Centres trades on a -5.5% discount to its December 2016 net tangible assets and, with gearing of 24%, CLSA expects a buy-back will be announced.

The broker is also of the view that the company should consider selling off around $1bn in lower quality assets that could be used for capital management. CLSA, not one of the eight stockbrokers monitored daily on the FNArena database, has a Buy rating on Scentre Group with a $4.92 target and an Outperform rating on Vicinity Centres with a $2.82 target.

UBS upgrades Scentre Group, GPT ((GPT)) and Vicinity Centres to Buy from Neutral on valuation grounds, after considering the Amazon threat in more detail and believing this is now priced into the stocks.

The broker considers Scentre Group and Vicinity Centres oversold on the Amazon threat and now present strong value. At the same time the market has become too negative on GPT's retail portfolio and the company's premium Sydney/Melbourne office portfolio is considered the best way to gain exposure.

UBS believes the concerns over the online threats are overplayed for the retail A-REITs after taking into account the shopping centre landscape in Australia. Australian landlords are envisaged well-positioned to compete, considering retail space per capita, favourable demographics population densities and the mix of tenants/sales.

With the introduction of Amazon the broker anticipates online sales penetration to increase to 19% from 11% (ex food) by FY23. The broker estimates the retail A-REITs are trading on a 6.0% cap rate, which compares with the December 2016 stated weighted average rate of 5.3%.

On an annual rolling basis retail A-REITs have underperformed the sector by around -26% and valuation metrics suggests the risks are now priced in. Those A-REITs UBS suggests are most exposed if Amazon takes share from bricks & mortar retailers include Scentre Group, while GPT and Stockland ((SGP)) rank lowest.

Another retail tenant is added to Macquarie's watch list for retail A-REITs, food. These tenants appear to operate on very low margins and increased competition from the continued rolling out of food tenancies into malls is eroding returns, leading to lower rents.

When the food category is added to Macquarie's prior analysis of shopping centre tenants, around 44% of a shopping centre income is at risk. For example, a -10% reduction in income from these categories over time would result in up to a -4% headwind for those under coverage. Macquarie emphasises that this is material, as most retail A-REITs are growing income at around 2%.

Furthermore, the top five shopping centres for each A-REIT are generally 37-73% of the retail portfolio value and this warrants ongoing attention. These particular centres are typically higher growth and/or in more affluent catchments.

Macquarie also observes that retail A-REITs will keep pushing for higher densities. Vicinity Centres, in particular, has excess car space versus other A-REITs, equating to around $0.14 per share of potential value.

Macquarie concludes that, while retail has been a problematic segment this year, as sales have slowed over the past 12 months and stress levels on the tenant base are increasing, a lot has now been factored in.

Residential

Macquarie also updates the outlook for residential A-REITs and shifts to a more cautious stance, factoring in a greater cost of credit and the relative difficulty in accessing credit, particularly for the investor segment of the market. Macquarie prefers Queensland and Victoria going forward because of positive interstate migration.

On in individual basis, reflecting the recent sell-off to levels suggesting a more attractive total shareholder return, Macquarie has upgraded Dexus Property ((DXS)), GPT and Vicinity to Outperform from Neutral and Scentre Group and Westfield ((WFD)) to Outperform from Underperform.
 

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