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A-REITs Subdued Despite Low Bond Yields

Australia | Sep 11 2019

Australia's real estate investment trusts, as a group, have outperformed the broader equity market but remain relatively subdued, largely because of the dominance of shopping centres.

-News flow very negative for shopping centres
-Fund managers better placed in current yield environment
-Moderating economic growth likely to impact on office leasing conditions


By Eva Brocklehurst

Operating conditions continue to vary among the segments of Australian Real Estate Investment Trusts (A-REITs). The headline valuation of the sector appears attractive, as history indicates a decline in bond yields means listed property outperforms broader equity markets.

Yet Macquarie points out, while this remains the case in 2019, the strength of the outperformance has been relatively weak, attributed in part to an A-REIT index which has significant exposure to retailing that, in turn, is facing uncertainty over cash flow.

Hence, the sector is not as defensive as it once was. The price/earnings multiple of the A-REIT sector is at a -0.8 percentage point discount relative to the ASX 200, having inverted from a 1.7 percentage point premium since May 2016.

Macquarie expects a decline in equity market volatility, as further cuts to official interest rates in the next 12 months provide for higher asset values and less volatility. In times of rising volatility, the broker observes the A-REIT sector typically outperforms. The FY19 reporting season has reinforced Macquarie's view on retail, as operating income growth was disappointing and occupancy costs rose.

Citi agrees the news flow has been very negative for retail and a further slowing of income growth is likely, amid growing evidence that shopping centre values are falling. The broker has maintained an increasingly bearish conviction on retail A-REITs.

Macquarie, too, remains cautious about the current leverage of retail vehicles and queries the active buybacks of both Scentre Group ((SCG)) and Vicinity Centres ((VCX)), downgrading the latter to Underperform recently. Moreover, Morgan Stanley lowers expectations for retail REITs globally, driven by a combination of rising fears of a recession and escalating trade wars that may adversely affect retailers.

While retail sales growth has shown some signs of life in the latest ASX reports, this has not translated into comparable income growth for many A-REITs, Baillieu asserts. The broker believes the outlook for the sector is skewed to double-digit earnings growth expectations for large-cap stocks such as Charter Hall ((CHC)) and Goodman Group ((GMG)).

Fund Managers Highlighted

Meanwhile, Charter Hall , Goodman Group and Lendlease ((LLC)) have fund management platforms which continue to benefit from a lower-for-longer yield environment. This outlook for fund managers is superior to passive retail A-REITs, in Macquarie's opinion.

Citi observes earnings growth for the sector based on company guidance is around 4% and any surprises to the upside are becoming more concentrated, with only Charter Hall, Goodman Group and Charter Hall Long WALE ((CLW)) offering above-sector earnings growth.

Macquarie expects operating conditions for the office segment will be less positive, highlighting Dexus Property's ((DXS)) view that any moderation in economic growth would impact on leasing conditions.

Charter Hall's wholesale funds have been busy over August, forming a new joint venture that will co-own the leasehold of Chifley Tower in Sydney. JPMorgan notes Charter Hall will manage the tower and its funds under management have increased by $1.8bn as a result.

The company, along with Abacus Property ((ABP)), has also entered into an agreement to acquire 201 Elizabeth Street Sydney from Dexus and Perron for $630m on a 5% yield. Charter Hall, along with partners, will take a 68% stake in the tower and Abacus Property will acquire the balance.

Stockland Group ((SGP)) is recycling capital, selling a 50% stake in 135 King Street and the Glasshouse retail complex and using the proceeds to acquire the remaining stake in Piccadilly Centre.

Despite positive momentum in residential markets, Macquarie recently downgraded Stockland to Neutral, given a flat distribution outlook. The preferred residential exposures are Mirvac Group ((MGR)) and Peet & Co ((PPC)). Citi made one rating change post the reporting season, upgrading Mirvac to Buy. The broker believes the leading indicators for residential are pointing to a recovery but the impact on earnings may only emerge in FY21.

Lendlease is now the broker's top pick in the A-REIT sector and could significantly outperform post the sale of its engineering business. Citi's least preferred names are Scentre Group, BWP Trust ((BWP)) and Stockland.

Floor Space

South Africa's Woolworths Holdings is looking to rationalise the footprints of retailers David Jones and Country Road Group. Noting similar intentions from store chains Myer ((MYR)) and Big W ((WOW)), Macquarie suggests backfill will be difficult.

David Jones intends to reduce floor space by -20% by 2026 and has announced an onerous $22.4m lease provision. This reduction in the footprint was originally intended to occur upon the expiry of leases but the company has indicated it will now proceed more aggressively.

Regional locations are likely to be targeted, as the company intends to reduce its exposure to lower demographic areas. David Jones has 47 stores in Australia, with 10 in regional locations. Scentre Group has the largest shopping centre exposure to David Jones, with 17 stores of which two are in regional locations.

Macquarie notes Scentre Group's David Jones weighted average lease expiry is nine years. Country Road Group is intending to reduce its footprint by -9% on a net basis by 2022 and achieve sales-based rents as opposed to fixed rents.

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