Office Assets Put Dexus In The Box Seat

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Strong cash flow, positive leasing spreads and lower debt costs are delivering superior returns for Dexus Property, which is currently enjoying a robust outlook for office and industrial assets.

-Increasing certainty regarding property income and funds management earnings
-At some stage Dexus will need to pursue capital recycling or raise further equity
-Key leasing risks emerging in FY22
 

By Eva Brocklehurst

With many avenues for growth Dexus Property ((DXS)) is in the box seat among those Australian real estate investment trusts (A-REITs) with a focus on office and industrial assets. Operating conditions remain favourable for office landlords and the company's trading profits appear secured for FY20 and FY21.

The highlight of the first half for UBS was office income growth of 8.9%, supported by Sydney leasing spreads of 18%. Capitalisation rates (the net operating income of a property compared with its value) continue to compress but strong cash flow, positive leasing spreads and lower debt costs are delivering superior returns for Dexus in an A-REIT context.

Moreover, Citi notes visibility out to FY22 is increasing. The potential profit from the trading book has increased to $245-315m. Gearing at 25.5% leaves the company with around $1bn of debt-funded investment capacity before gearing exceeds 30%.

However, this is not enough to fund the entire development of $5.7bn that is “on balance sheet” and at some stage the company will need to pursue capital recycling or raise further equity, Credit Suisse points out. The share buyback remains a capital management option but the broker considers this a last resort and does not assume any further shares will be bought back.

There is also scope for third-party capital injections, given global demand for good-quality real estate, and funds management is now up to $17bn. All up, Credit Suisse considers the business well-placed to leverage continued global demand for good real estate, particularly in the office and industrial sectors in Australia.

Ord Minnett points out operating conditions have slowed, although this is not enough to bring the defensive nature of the stock into question. Net absorption in office markets, with the broker citing JLL Research, declined in 2019 for Sydney and Melbourne CBDs.

Upgraded Outlook

Free funds from operations (FFO) growth of 4% is now expected for FY20, versus 3% previously, and distributions growth has been upgraded to 5.5% from 5.0% previously. Macquarie finds the latter upgrade curious when compared with the upgrade to earnings and suspects management is being conservative.

Morgan Stanley assesses the upgrade to earnings growth is predominantly driven by lower interest rates and Dexus did not change its office or industrial rent forecasts.

The company has been actively developing its portfolio, with the pipeline increasing to $11.2bn. Dexus has a 51% share of this number and Macquarie suspects profits could be significant over time. Timing and trading profits will be key going forward, the broker adds.

Delays

Nevertheless, Dexus has indicated that the AMP Circular Quay tower may be delayed to 2023, which could mean Sydney CBD is net withdrawals in 2022. Macquarie asserts that developments expected to be completed in 2024/25 are at risk of delays, and a case in point is Dexus noting its Pitt Street development will not be completed until 2027.

Nevertheless the positive outlook for the business is based on rising asset values, and Macquarie points out a more protracted supply outlook would be positive for office landlords more broadly.

Several items were considered not so rosy. Office occupancy declined in December to 97.4% from 98.0% as of June and this is likely to be a drag on office income in the second half. Capital intensity is also higher, as are office leasing incentives. Under-renting, overall, is still around 1% on an effective basis, albeit declining from the 4% experienced in FY19.

The main leasing risk, Credit Suisse notes is 123 Albert Street Brisbane in FY22, which represents 3.6% of the office portfolio. Morgan Stanley also highlights the leasing challenges faced at 123 Albert Street and expects earnings growth will diminish in FY22 to around 3.0% from a forecast of around 4.5% in FY21.

FNArena's database has five Buy ratings and one Hold (Morgan Stanley). The consensus target is $13.58, suggesting 5.0% upside to the last share price. The dividend yield on FY20 and FY21 forecasts is 4.1% and 4.3% respectively.

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