Bumpy Road For A-REITs But Value Remains

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Several factors have combined to make January the worst month in six for returns from A-REITs. Yet several brokers suggest there is value in individual stocks.

-Sector balance sheets healthy and pay-out ratios considered sustainable
-Macro headwinds likely to work against the sector in coming months
-Office supply likely to hit the leasing market in second half of 2018
 

By Eva Brocklehurst

Australian Real Estate Investment Trusts (A-REITs) may be set for a tough year in 2018 as the housing market peaks and consumer confidence remains modest. Moreover, synchronised growth in trade and tax cuts in the US, as well as the high Australian dollar, have also hindered the sector.

All A-REITs in the S&P/ASX200 showed negative total returns in January and the index fell -3.3%, its worst returning month since June 2017. Ord Minnett notes the least affected were retail landlords Scentre Group ((SCG)), Vicinity Centres ((VCX)) and GPT ((GPT)) because of improved consumer sentiment. Abacus Property ((ABP)) was the worst affected.

Filtering out the good news, UBS suggests the sector could return $7bn in capital if the Westfield ((WFD)) sale transaction is completed and direct asset values strengthen.

More capital management could ensue if material discounts to net tangible assets (NTA) emerge. UBS forecasts a 5% distribution yield in 2018. The broker envisages the sector trading at a -4% discount to fair value versus a long-run average discount of -6%.

Credit Suisse notes A-REITs trade on a 6.4% prospective earnings yield, 5.2% distribution yield and at a 21% premium to NTA. Historically. the premium to NTA has been 16%. On the broker's estimates sector earnings growth will accelerate in FY18 to 4.6%.

Structurally, at least, Shaw and Partners notes the sector is in good shape and balance sheets are generally healthy, with sector gearing of 26.8% on average. Furthermore, distribution pay-out ratios are also conservative and sustainable, at 82.2% on a weighted average basis.

The broker does not expect any material downgrades to earnings in the upcoming reporting season, capitalisation rates are not expected to soften in 2018 and there appears little downside risk to valuations.

That said, the broker suspects macro headwinds – rising bond yields, US tax cuts and high AUD – will work against the sector in the short term, while tailwinds are not so evident. The sector is not expected to outperform the broader market in 2018 but the broker finds value in individual stocks.

Retail

Retail headwinds appear priced in to UBS and there are upside risks if specialty retail sales find a base in the second half. If the housing market – Sydney and Melbourne are already off the boil – slows gently, with no official rate increases, earnings are expected to surprise on the upside.

UBS prefers exposure to Scentre Group, the option value in Westfield regarding potential for a counter bid, and Vicinity Centres. The broker's least preferred in this sector is GPT, where a material slowing of income growth is expected, and the stock is downgraded to Neutral from Buy.

Shaw and Partners rates both Scentre Group and Vicinity Centres as a Buy in this segment.

Office

Meanwhile, office fundamentals are strong but UBS notes this is a crowded trade and the next supply cycle is expected to hit the leasing market in the second half.

The broker remains positive on Sydney and Melbourne's office fundamentals but retains an anti-consensus stance on Dexus Property ((DXS)), with a Sell rating. Shaw and Partners also has a Sell rating on Dexus.

Following the exit of Cromwell Property ((CMW)) from the Investa Office ((IOF)) registry UBS believes the potential overhang has now been dealt with. Weak cash flow is priced in for FY19.

The broker envisages some upside from recent leasing success and upgrades Investa Office to Neutral from Sell, although recognises synchronised global growth expectations are likely to weigh, as well as bond yields.

Residential

Risks are building in the Australian residential segment amid high household debt and falling house prices, although population and employment growth mitigate this somewhat.

UBS expects Stockland ((SGP)) to outperform Mirvac ((MGR)) on the back of high-margin Sydney settlements and strength in Melbourne. The broker downgrades Mirvac to Hold from Buy.

Shaw and Partners has a preference for Stockland and Lend Lease ((LLC)). The broker also rates Centuria Capital ((CNI)), and Centuria Metropolitan ((CMA)) as Buy.

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