What’s The New Deal For A-REITs?

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As the economy re-opens, defensive Australian A-REITs are expected to perform, with an increasing focus on industrial themes, while there are some significant risks facing the retail segment.

-Online momentum expected to drive rationalisation of retail outlets
-Rental receipts in shopping centres expected to be under pressure
-Divergence in demand for office/industrial space depending on product
 

By Eva Brocklehurst

What is the outlook for the Australian real estate investment trusts (A-REITs) as the economy starts to open up again? Will the trends witnessed during the lockdown persist?

As economies re-open, Macquarie suggests those A-REITs with defensive characteristics will continue to perform. Aside from the issue of tenancies, the broker notes Stockland Group ((SGP)) had the most defensive portfolio in March, outperforming traditional peers.

In the office, the return to work appears set to be slower than previously anticipated, as workstation separations and elevator restrictions constrain the number of workers that can be physically accommodated.

This is the scenario JPMorgan suspects will characterise the re-opening of the economy. Moreover, public transport aversion is likely to continue for a while. Hence, activity may not get back to what is previously been considered "normal" for some time.

Meanwhile, the shift to online purchasing has gained momentum with the lockdown, and this is expected to drive the rationalisation and consolidation of retail outlets. UBS flags the potential for around 20% of mature specialty stores to close by FY24, although there will be less impact on landlords with an ability to curate and remix space.

The broker forecasts around 1.5% of retail space, or 4% of income, is vacant and specialty rents are likely to reduced by -20% as landlords adjust to maintain occupancy.

While shopping centre A-REITs may be supported by a short-term resurgence in trade, as pent-up demand is released after the lockdowns ease, there are longer-term structural challenges and limited growth prospects, in the broker's view.

The downside risk to retail property owners is acute, Citi agrees, as retail space has been added ahead of demand for a number of years and closure of anchor tenants or the shrinking of stores more generally only exacerbates the issue.

Proactive landlords have plans in place to address the risk but it's not clear if all these are executable post the pandemic and this is a difficult time to deal with unexpected vacancies. Moreover, the need to absorb additional space adds to the risks of lower rents.

Tenancies

Morgan Stanley assumes that from October 2020, when temporary relief provided by the government ends, rental receipts for both Vicinity Centres ((VCX)) and Scentre Group ((SCG)) will be around 20% of the previous "normal" levels.

This assumes a 5% vacancy rate, -10% decline in specialty sales, a -2.5% fall in occupancy costs and lower rent for the anchors. Any rental resets will likely happen over a number of years as the leases expire, the broker acknowledges, while using October as the key point in time, to keep assessments simple in light of the uncertainties.

Morgan Stanley believes it has erred conservatively in its numbers, although acknowledges a case for deeper cuts to estimates could be made. Moreover, it appears retail landlords are only just beginning rental relief discussions as sales data from tenants is finalised.

The broker notes specialty tenants in some number are refusing to pay April and May rents until a relief formula is locked in. The main risk is another lockdown, if there is a second wave of the pandemic.

In terms of attracting and retaining tenants, Morgan Stanley suspects those shopping centres that have been redeveloped could be the winners, as the "most relevant" or "shiniest" will attract renewals and backfill tenants.

However, redevelopment plans may now be harder to justify for older, more shabby centres. Hence, the broker prefers Scentre Group as it has recently spent some money improving its assets. The company has spent $2.9bn in redeveloping 17 of its 42 shopping centres since 2014. Vicinity Centre has spent around $1.8bn in redevelopments and, whilst a positive, Morgan Stanley points out this is concentrated at just two assets.

Target

Meanwhile, Wesfarmers ((WES)) has confirmed the first phase of its review of Target. Around 10-40 large format stores will be converted to Kmart and 10-25 will be closed. Target Country will also be restructured.

In summary, around 50% of the stores will either be closed or converted to Kmart. This is a concern for the retail landlord, although Morgan Stanley points out Target is not a huge payer of rent despite the large spaces being occupied.

Still, around 30% of the stores are located in A-REIT-owned centres and there is the risk of additional impacts from the phase 2 announcement expected from Wesfarmers in August, Citi asserts, believing this announcement highlights the structural pressures facing the sector and shifts the supply/demand balance further in the tenants' favour.

Morgan Stanley assesses the 19 Target stores at the Vicinity Centre malls make up just 1.6% of its income while JPMorgan notes Charter Hall Retail ((CQR)) has five full-line Target stores and five Target Country stores in its portfolio, contributing to just over 2% of income.

The latter is in advanced discussions with potential replacement retailers in areas where it suspects Target may close. Citi agrees Charter Hall Retail has the greatest income exposure to Target, while Scentre Group has the highest number of Target stores, given its scale, with many co-located with Kmarts, which reduces the scope for conversions.

Macquarie points out conversions are preferred to closures and low-productivity centres will be the prime candidates for closure. Closures create issues for landlords because of the expenditure required to backfill and the lost income in converting to alternative use. Wesfarmers has indicated it will complete the bulk of its closures/conversions by the end of 2021.

Office/Industrial

The recent increase in e-commerce is likely to be positive for tenant demand in industrial sites, with Macquarie noting Charter Hall Group's ((CHC)) recent re-leasing of developments as proof. Goodman Group ((GMG)) was also optimistic about rentals, expecting development work will grow to over $5bn by FY21.

However, the broker notes more conservative commentary emanating from the US and EU on developments and continues to believe there is a risk of a more modest outcome.

Macquarie is also concerned about the medium-term outlook for rents and valuations in the office segment, because of softer demand over coming months. Both Charter Hall and Dexus Property ((DXS)) believe office density will decline as a result of the pandemic and Charter Hall expects 2020 will reveal a greater level of industrial transactions.

Dexus has indicated there is a divergence in demand currently, dependent upon a company's exposure to discretionary or non-discretionary product. Still, tenant demand is generally strong for well-located buildings.

Goodman Group has signalled increased demand for both temporary and permanent space from customers in the food, consumer goods and logistics sectors particularly related to e-commerce operations and those transitioning to online.

Residential

Lastly, in residential, near-term defaults have been better than Macquarie expected, however sales going forward are likely to reflect pent-up demand and an immediate rebound is not expected. The broker recently downgraded Mirvac ((MGR)) because of a more cautious stance on the medium term outlook amid residential concerns.

Defaults are under control to date, Macquarie notes, and settlements for both Stockland and Mirvac are expected to hit targets, although the all-important fourth quarter is ahead.

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