Feature Stories | Apr 20 2020
The government has enacted a Code of Conduct regarding landlord rent relief for SMEs, while large tenants are in negotiations, all of which will impact on REIT valuations and distributions.
-Code of Conduct enforces rent waivers
-Retail REITs hardest hit
-Office under pressure, industrial less so
-Pubs well positioned
-Another hit for insurers
By Greg Peel
Late in March, retailer Premier Investments ((PMV)), owner of brands including Just Jeans, Jay Jays, Jacqui E, Portmans, Dotti, Peter Alexander and Smiggle, informed investors that due to the lockdowns, it would close all of its 1200-odd stores worldwide and stand down all of its 9000 staff, barring a handful of head office staff, at least until April 22. Executives would work from home.
The company also told investors it would not be paying any rent on those stores during the closure period. While this seemed like a bold move, some 70% of Premier’s store leases either expire this year or are in holdover, providing the company with “extraordinary” flexibility come lease renegotiations during the crisis.
In response, Scentre Group chief executive Peter Allen said he was "surprised" to see Premier announce a shutdown, saying it was "premature" while the government was still working through options for workers, the Fairfax press reported. Scentre holds 219 Premier stores in its portfolio.
"There is a legal obligation to pay rent even if the stores close and that legal obligation means we must engage in commercial discussions with our tenants," Mr Allen said.
Premier Investments was not the last retailer to announce a pre-emptive suspension of rent payments.
The government has since settled on its JobKeeper and JobSeeker relief schemes, albeit they appear to remain fluid as overlooked worker subsets make themselves known, and had flagged action on rent relief pending getting this immediate worker support established.
One might ponder a scenario in which the government were not to intervene, leaving landlords and tenants to argue over rents themselves, even at the housing level. It would not be a simple matter of evicting the retailer who can’t cover the rent, or the housing tenant who had lost his/her job, because with all non-essential retail shut down and the sheer extent of job losses across all industries, who might the landlord find to replace those tenants in the meantime?
At the very least, heavily discounted rents might need to be offered, when prior to the shutdowns, that tenant was a valued, reliable rent payer. Thus while it is clearly in the interest of tenants not to pay rent at this time, it is also in the interest of landlords to come to some arrangement both parties can cope with until the smoke clears.
At the big end of town, retailers like Premier Investments and landlords like Scentre Group can negotiate such arrangements, but smaller retailers don’t necessarily have the clout. Hence the government last week announced a Code of Conduct on Small & Medium Enterprises Commercial Leasing Principles, to be used as a benchmark.
The Code was not simply cooked up by the federal cabinet or national cabinet but was developed by parties on both sides of the argument, being the Australian Retailers Association, the National Retailers Association, and the Pharmacy Guild of Australia in the red corner, and the Shopping Centre Council of Australia in the blue corner, which is chaired by none other than Scentre Group CEO Peter Allen.
The Code sets out fourteen principles to guide the dealings between landlords and SME tenants across all of retail, office and industrial properties which have lost business as a result of the pandemic, and are participating in the government’s JobKeeper program, which provides wage assistance to companies if those companies retain idled workers.
These are principles, not laws, although landlords cannot evict their tenants and tenants must honour their leases, meaning they can’t just walk away.
The Code does not preclude any landlord negotiating its own bespoke deal, satisfactory to the tenant, to account for specific circumstances. The government also expects Australia’s banks and other financial institutions to play their part in providing flexibility to both parties.
The Code directs landlords to offer rent reductions in proportion to the loss of trade suffered by the tenant during the shutdown period and in line with a reasonable subsequent recovery period. Reduction amounts can be a mix of rent waivers and rent deferrals but full waivers must make up a minimum of 50% of reductions, and the lease may be extended by the duration of waivers and deferrals.
Thus if a retailer, for example, has lost -80% of its turnover in the shutdown, the landlord must reduce the rent by -80%, made up of at least 40% fully waived and the balance deferred to a later date that allows a reasonable period for that retailer to be back towards “normal” business.
The tenant must have had a prior turnover of less than $50m annually and must be eligible for the JobKeeper scheme, which means only those businesses having seen a -30% fall in revenue or more.
As noted, it’s up to the bigger end of town to fight its own battles.
The challenge now for stock analysts is to take these directives on board in adjusting landlord (real estate investment trust) valuations across the retail/office/industrial sectors, and make assumptions about to what extent larger retailers and other businesses might be appeased by tailored negotiations with their own landlords, all without knowing just how long the shutdowns will last.
And that’s not the only great unknown.
The popularity of online shopping has been growing for years but with many consumers now left will little choice but to shop online, perhaps for the first time, positive experiences will potentially drive a step-jump in proportionate online sales in a post-virus world. Remember when it comes to rents, we’re talking bricks & mortar here.
Office workers are working from home, and if they find the experience quite manageable using today’s technology that simply did not exist in the nineties recession and was only in its very infancy in the GFC (the first iPhone became available in 2007), and indeed beneficial to the work/life balance, then maybe spending at least some hours or days a week working from home may become the new trend.
If employers similarly find business runs quite smoothly in such a scenario then they could choose to cut down on required, costly office space.
Rent reductions are one metric to evaluate on either side of the landlord/tenant equation, but lower bricks & mortar demand and thus subsequently lower retail/office space valuations in a new world post-virus are another matter to consider when sizing up REITs.
One might say the climate has become “cloudier”.
We Are Closed
Clearly in the current environment retail property is the hardest hit REIT sector, followed to a lesser extent by office, and perhaps to a minimal extent by industrials. The fastest growing sub-sector within industrials, with a bullet, is logistics, which represents distribution centre bricks & mortar for everything from essential supermarket supplies to discretionary online shopping purchases.
GPT Group ((GPT)) is a diversified REIT with a finger in all three pies. The property fund manager has been quietly shifting out of retail exposure towards industrial, and on last count showed a balance of around 43% retail and 57% office/industrial. GPT has become a flag bearer, being the first REIT to announce valuation write-downs of its assets.
GPT announced last week it had marked down the value of its wholesale unlisted office fund by -2%, and its retail funds by -11%.
Morgan Stanley has taken these mark-downs as a benchmark in projecting the impact on gearing levels for other retail REITs, while noting GPT’s retail fund had already reported negative comparable specialty retail sales growth in 2019, so it was not a great starting point to begin with. Clearly no two retail REITs are identical.
But assuming the same -11% valuation mark down, Morgan Stanley estimates, all else being equal, Scentre Group would see its gearing level increase to 38% from 34% currently, Vicinity Centres ((VCX)) to 31.5% from 28%, Charter Hall Retail ((CQR)) to 37% from 33%, and Shopping Centres Australasia ((SCP)) to 37% from 33%.
Gearing levels are significant when it comes to covenants on bank financing. Ord Minnett notes that retail REIT balance sheets and liquidity positions are generally sound, but the focus is on increasing loan-to-valuation ratios. The broker believes retail REITs to generally withhold their June half dividend payments to preserve capital, and to reduce longer term dividend payout ratios to ensure LVRs do not materially increase.
Ord Minnett has adjusted its valuation models to take into account short term rent abatements (50% rent waiver for six months for impacted tenants), noting that the overall impact varies by REIT dependent on retailer exposure. Longer term the broker rebases specialty retail rents lower by -5-20% dependent on retailer mix and rental costs.
Ord Minnett acknowledges retail REIT valuation risks are to the upside following a market battering, but warns newsflow and short term earnings and valuation momentum remain to the downside. To that end the broker advises sector underweight positions should be brought back to market neutral but it’s too early to move to overweight.
Among individual REITs, Ord Minnett has lifted BWP Trust ((BWP)) to Neutral from Sell and retained Neutral ratings for all of Scentre Group, Shopping Centres Australasia, Vicinity Centres and Aventus Group ((AVN)), while lifting Charter Hall Retail to Buy.
Morgan Stanley has factored in an -80% rent cut across the board paid to Scentre Group and Vicinity Centres to June, and -50% in July to September, which will affect 2020 net operating income (revenue) and funds from operations (earnings). But the broker also flags some uncertainty with regard how landlords account for rent relief.
Deferred rent will still be accounted for as 2020 income, even if it were to be paid in later months, which means there would be no actual impact on revenue and earnings in the period. However rent waivers are a different matter. Typically, rent-free periods are treated as an “incentive”, the broker notes, thus taken below the line and “capitalised”. This implies a 50/50 mix of waiver and deferral would result in a negative impact -0-50% on revenue and earnings, rather than the full hit many investors are expecting.
But even the REITs themselves are unsure at this point, and will be seeking accounting advice.
That’s the near term. In the longer term, the question is will everything just return to normal post-virus, or could we see a structural change?
Morgan Stanley believes longer term rents could drop by -20% below pre-virus levels given the structural decline in bricks & mortar shopping already underway would be accelerated by more shoppers going online out of necessity during lockdown, and then sticking with online thereafter. As to what extent individual retailers are affected would be dependent on whether foot traffic does decline post-virus, what level of online offering the retailer has and whether online margins are dilutive to earnings.
The broker suggests lower long term rent would be net positive for retailers but dependent on what level of foot traffic is lost.
Morgan Stanley sees the most earnings upside for The Reject Shop ((TRS)), being 81%, as it has the lowest starting margins, followed by Premier Investments on 25% and Accent Group ((AX1)) on 24%. The broker sees Premier and Accent, along with City Chic Collective ((CCX)) as well placed in the online market to offset lower in-store revenue, compared to The Reject Shop and Lovisa Holdings ((LOV)), which have limited online offerings.
Nothing So Lonesome
Pubs and clubs have been shut down since March 20. While major tenants are continuing at this stage to pay rent, not being eligible for government enacted rent relief, future rent negotiations have not been ruled out.
ALH Group, owned by Woolworths ((WOW)), is the major tenant of ALE Property Group ((ALE)). Woolworths had been looking to divest of its Australian Leisure & Hospitality business due to negative ESG implications but has since stalled proceedings during the virus crisis. ALH continues to pay rent as it is not eligible for Code of Conduct relief and has no mechanism within its leases that would oblige ALE property to provide rent relief.
However, JPMorgan believes a negotiated outcome remains a possibility should ALH seek some form of waiver or deferral. ALE Property had already been conducting rent reviews on 43 venues which are expected to be completed by the end of FY20, at which point the REIT will also revalue its portfolio.
ALH Group is also a tenant of Hotel Property Investments ((HPI)), as is QVC, the equivalent owned in a joint venture by Coles ((COL)) and KKR. However, the bulk of the REIT’s tenants are small operators to whom Hotel Property has already granted rent waivers to help them through the lockdown, and as such the REIT has withdrawn dividend guidance.
JPMorgan believes that while commercial property valuations will come under pressure as a result of the virus, pub landlords and other long WALE (weighted average lease expiry) REITs are relatively well positioned. The broker has factored in only a -5% reduction in property valuations over 12-18 months.
Before the virus even hit, Goldman Sachs was forecasting increasing office vacancies as the completion of new developments coincides with a sharp drop in tenant demand. The broker had forecast vacancy rates to drive rent reductions of -18% in Sydney and -23% in Melbourne over 2020-22.
Revised modelling now suggests -30% and -34% respectively.
Goldman Sachs also expects near term revenues to be impacted by the need for assistance for tenants experiencing financial difficulty, and assumes tenants accounting for 25% of revenue receive three months of rent waivers across office portfolios.
Net demand for office space in the Melbourne CBD was -87% down in 2019 from 2018, JPMorgan reports, and turned negative in the March quarter 2020. In the Sydney CBD, space vacated by tenants in the March quarter was equivalent to all of that in 2019. The broker expects Sydney to remain negative through 2020 and into 2021, while Melbourne is about to hit the largest increase in net office space supply in the last 29 years.
Goldman Sachs expects vacancy to hit 10%-plus in both markets this cycle, compared to an earlier forecast of 7-8%.
The broker has subsequently cut its forecasts for Stockland Group ((SGP)), Dexus Property Group ((DXS)), GPT Group and Mirvac Group ((MGR)). Stockland and GPT attract Buy ratings, Mirvac Neutral and Dexus Sell.
Macquarie is focusing on tenant performance, which should underpin leasing discussions. Meanwhile, the broker has a preference for industrial and office REITs over retail, which means logistics REIT Goodman Group ((GMG)), Mirvac, Dexus and Charter Hall Group are preferred over Scentre Group and Vicinity Scentres.
Then there are the insurers.
Macquarie has had a close look at Loss of Rent insurance policies as unemployment threatens to increase, estimating that if 5% of at-risk Loss of Rent policies are required to pay claims, the insurance market could incur a loss of some -$90m.
That said, the broker notes there is a growing social pressure for insurers to “look through” eviction clauses, which would make estimated losses larger.
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