Relative Value And Returns Driving A-REITs

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Despite the difficult year ahead brokers are largely positive about A-REITs, as valuation discounts combine with potential returns and asset values remain supportive.

-Relative value rather than a supremely positive outlook drives many recommendations
-Quality is increasingly important for retail assets, as Amazon offer improves
-Main issue for office segment is the downtime on large tenant leasing
 

By Eva Brocklehurst

Softening retail conditions and a housing market past its prime affected Australian Real Estate Investment Trusts (A-REITs) as 2017 passed, although brokers note a stabilising of the sector has allowed value to emerge.

As the equity market moved to reflect changes in long bond yields, the sell-off of in A-REITs was greater than Macquarie expected, relative to underlying asset values on a 12-month view. This provides the potential for the sector to trade at discount to net tangible assets (NTA).

The sector appears to have stabilised recently, down -1.0% on a rolling month basis versus the overall market down -0.8%. Macquarie remains overweight on growth vehicles such as Goodman Group ((GMG)), Mirvac ((MGR)), Lend Lease ((LLC)) and Charter Hall ((CHC)).

The broker observes sales levels were generally slower in residential during the latest reporting season, although settlements materialised as expected. Office conditions continue to improve and are expected to outpace retail in the months ahead.

UBS suggests a difficult year is in train. On the good news front, valuation discounts are combining with potential returns and direct asset values remain supportive. Income growth slowed throughout 2017, yet Ord Minnett also finds value in a sector which is trading at an -11% discount to valuation and on a 5.9% free cash flow yield.

Ord Minnett tweaks its pecking order and downgrades Lend Lease to Lighten from Hold. National Storage REIT ((NSR)) is lowered to Lighten from Hold while Viva Energy ((VVR)) is raised to Buy from Accumulate.

Retail

Despite the negative news flow surrounding retail outlet closures, Shaw and Partners finds occupancy levels remain high and landlords are still generating income growth at the portfolio level. Occupancy costs are rising, nevertheless, and this will raise the issue of the sustainability of rental increases if low retail sales growth persists.

Western Australia has been the weaker region, while NSW and Victoria remain relatively strong. Gearing rates remains low for most of the retail landlords, providing a buffer against any unexpected decline in asset values, which is considered unlikely in the short term.

Relative value rather than a positive retail outlook drives the Shaw and Partners recommendations. The broker maintains Buy ratings for Vicinity Centres ((VCX)), Scentre Group ((SCG)), Mirvac and Stockland ((SGP)).

Morgan Stanley suspects Stockland's portfolio may prove to be more resilient than many currently expect. Increased capital is being allocated from a diversified business, specialty sales are recovering and the company has greater exposure to essential services. The broker also remains Overweight on Vicinity Centres because of the scope of self-help, although acknowledges the risk of register rotation limits the potential for outperformance.

UBS believes retail specialty sales growth has bottomed and quality is now the performance measure. The broker considers Scentre Group and Westfield ((WFD)) are winners in this aspect, whilst Stockland is lagging.

With specialty sales growing by just 1.2% across the sector, Morgan Stanley envisages further downside to re-leasing spreads and comparable net income growth. Book valuations signal that capital expenditure is becoming increasingly defensive and several assets are experiencing reductions in the December 2017 carrying values.

The broker also finds a divergence between aggregate and in-store retail sales. Morgan Stanley remains cautious about retail-exposed A-REITs, noting Amazon has rapidly improved its offer in Australia in terms of fullfilment, expanding the breadth of the offer and lowering prices considerably while improving delivery terms.

Residential

Ord Minnett expects residential margins to remain elevated for longer, noting land volumes are being affected by developers holding back releases. Lower investor demand is also seen having a meaningful impact on apartment sales.

Capital flows from apartment settlements are being returned to shareholders through buybacks, eg Lend Lease and Mirvac, although Ord Minnett cautions that a discount to NTA in isolation does not justify a buyback. In this aspect, Investa Office ((IOF)) and Vicinity Centres have halted buybacks.

UBS is cautious on Mirvac, as a weakening residential market is expected to overshadow earnings growth and the quality of trust assets. The broker expects fund managers will enjoy elevated performance/transaction fees, while developers are settling apartments with minimal defaults and rising land lot prices are supplementing margins.

Office

Office growth has been lower than market conditions might suggest, both UBS and Ord Minnett observe. UBS notes a number of reasons in individual names to explain why this is so. The main issue appears to be downtime from large single tenants. Major expiries are due in the short term for GPT ((GPT)), Dexus ((DXS)) and Investa Office.

Investa's expiries are well known and priced in, while UBS notes leasing and maintenance still need to stabilise for both GPT and Dexus, which are rolling off high expenditure on some of their larger buildings.

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