A-REITs Becoming Less Compelling

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Global bond yields remain an important driver of the relative performance of A-REITs, yet brokers suggest the sector has become less compelling following its recent rally.

-Distribution yield spread to bond yields now less attractive
-Demand for R/E assets supports strong growth in managers' FUM
-Citi suggests selling the retail rally
 

By Eva Brocklehurst

Australian Real Estate Investment Trusts (A-REITs) have rallied strongly over recent months and brokers suggest there is now less value in the sector. Macquarie moves its sector stance to Neutral but remains encouraged by the returns on A-REITs of 7.7% since January, ahead of the broader market and because of the rally in global bonds.

Global bond yields remain an important driver of relative performance for A-REITs. Risk still exists for higher bond yields but the broker forecasts the trajectory to be lower, with 3.1% expected by the end of 2019 versus spot yields at 2.6%. Moreover, the distribution yield spread to bonds of A-REITs is less compelling now. The sector yield has fallen around -60 basis points since March, to 4.9%, Macquarie calculates.

Other valuation metrics are also looking less attractive to the broker. On the other hand, direct market transaction activity has been strong for quality products, and asset sales have still achieved premiums to book value. This should support growth in assets over the reporting season.

Morgan Stanley observes demand for real estate assets has supported strong growth in Funds Under Management for those managers that derive 10-60% of earnings from fees. Structural demand for real estate could also mean less volatile active earnings going forward for those with a low proportion of performance fees.

The broker singles out Lend Lease ((LLC)), where the investment management business currently accounts for 20% of the broker's price target of $18.65. Holding other components constant, Morgan Stanley calculates a 12.7x implied valuation for Lend Lease investment management at the current share price.

This compares with 21.6x for Goodman Group ((GMG)) and 13.4x for Charter Hall ((CHC)). The broker suggests the visibility provided by the Lend Lease development pipeline may provide the next phase of the stock's re-rating.

Macquarie upgrades its target for Lend Lease by 20% to $22.00, factoring in greater confidence in profits from recycling capital as well as investment earnings. Macquarie increases the target for Charter Hall by 12% to $7.00 to reflect enhanced confidence in performance fees.

Citi retains among its top picks the fund managers Lend Lease, Charter Hall and Goodman Group and envisages further upside to share prices for all three. Each benefits from ongoing demand to invest in property, driving growth in FUM and expanding margins.

Strong Growth, M&A

Macquarie expects the sector's growth rate to improve to around 6.5% in FY18 after a relatively weak FY17 because of dilutive asset sales. This compares with the industrials sector expectations of around 1.4% growth in FY18.

Nevertheless, the broker believes the outlook in FY19 for industrials has improved to 13.4% after years of negative revisions post the GFC. Macquarie prefers those A-REITs that are genuinely growing earnings and believes Mirvac ((MGR)) and Unibail Rodamco Westfield ((URW)) offer the best value.

M&A is also likely to feature, and Macquarie's suspects those stocks trading at the smallest premiums or largest discounts to net tangible assets will be most susceptible. A significant dislocation in share prices could result in further M&A. The broker contemplates a dislocation in pricing for Mirvac, Stockland ((SGP)) and GPT Group ((GPT)) that may result in the breaking up of these diversified names.

Office Vs Retail

Office is the key A-REITs segment for brokers, while retail remains tough and residential is slowing. Citi expects office-exposed A-REITs will outperform those exposed to retail, as Sydney office rents are upwardly revised because of supply delays.

Mirvac, Macquarie highlights, has a solid near-term earnings profile and its exposure to office markets underscores its strength. Citi agrees, and suspects Mirvac's FY19 guidance could surprise on the upside, which may drive a near-term rally. The broker remains bullish on the office, industrial and funds management exposures of Goodman Group, Charter Hall, Dexus Property ((DXS)) and GPT.

Citi acknowledges the potential support provided by net asset valuations in the retail segment but envisages risks to this view, given the growing stock of shopping centres that are on the market.

The broker downgrades Scentre Group ((SCG)) to Sell, acknowledging this is a non-consensus call but believing structural headwinds indicate subdued rental growth beyond FY20. Macquarie also downgrades Scentre Group to Neutral from Outperform post the rally.

Moreover, there is potential for a drop in house prices to weigh on tenant sales and the stock's multiple, particularly given its 58% exposure to Sydney, Citi asserts. The broker also downgrades Shopping Centres of Australasia ((SCP)) and Charter Hall Retail ((CQR)) to Sell.

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