Australia | Sep 08 2020
Significant disruptions to rental returns for retail and office A-REITs have led to the scrutiny of balance sheets post the August reporting season but, is the market overdoing its concerns?
-Balance sheets positioned for future devaluations in retail and office
-Short term retail segment cash flow likely to be under pressure
-Alternative Long WALE A-REITs best performers during pandemic
By Eva Brocklehurst
As a volatile reporting season draws to a close, one main observation centres on the significant disruptions to the income of Australian real estate investment trusts (A-REITs). The majority have provided no guidance for FY21.
Yet there were some better-than-expected results from property fund managers and residential developers, UBS points out, as investors sought yield and entry-level home buyers took advantage of low interest rates and government subsidies.
Guidance has been limited this time, despite A-REITs typically providing quantitative earnings and distribution guidance. Most are choosing to keep distributions flat or slightly lower. JPMorgan assesses, aside from a couple of exceptions, balance sheets are positioned for future devaluations in retail and office, caused by a softening of the markets in these areas.
Macquarie asserts the market is mis-pricing the sector and there is value. The sector has underperformed the broader market by around -760 basis points in 2020 to date. The broker notes the only A-REITs with positive distribution growth are Arena REIT ((ARF)), Charter Hall Group ((CHC)) and Charter Hall Long WALE ((CLW)).
Earnings per share for the sector were down -9.5% in FY20 compared with consensus because of weaker retail rent collection and provisioning for rental relief, and are likely to be down a further -4.9% based on forecasts. This compares to industrials which were down -24% but expected to grow 6.4% in FY21.
Macquarie points out the use of FFO (free funds from operations) as the primary reporting measure for A-REITs ignores incentives to tenants, commissions to leasing agents and maintenance expenditure required for real estate. Hence, the broker prefers to focus on free cash flow generation, deriving this estimate by deducting maintenance expenditure and incentives from reported operating cash flow.
This indicates Mirvac ((MGR)) and GPT Group ((GPT)) may even need to write back provisions and, in the case of the latter, it would aid distributions, given this is based on free cash flow. Macquarie notes Dexus Property ((DXS)) is continuing to sell assets and highlights Stockland ((SGP)) is also shifting out of non-core assets.
Of note, JP Morgan has recently downgraded Stockland to Underweight because it was the best performing A-REIT in August. Its residential sales were strong and retail business better than peers. Hence, the good news is now priced in.
Retail net operating income was down -42% half on half in the second half for major retail landlords, following around $580m of rent waivers or provisions. While structural headwinds may be priced into retail, UBS agrees short-term cash flow will be under pressure and a second wave of coronavirus adds to the uncertainty.
Nevertheless, while the listed market is pricing in declines in asset values of -35% for shopping malls, and retailers will reduce store footprints, key locations still remain critical to business. Retail rents are likely to structurally re-base -20% lower, UBS calculates, and this will affect valuations.
Macquarie generally assumes rent relief will finish by the end of September and company-specific factors will then weigh. For example, Vicinity Centres ((VCX)) has a portfolio that is heavily exposed to Victoria.
Concerns over the balance sheet are likely to impact on Scentre Group ((SCG)) and Unibail-Rodamco-Westfield ((URW)). Both companies are considered candidates for equity raisings as they require reduction in financial leverage based on the broker's analysis.
Scentre Group indicated in August it does not intend to raise equity or divest assets, although Macquarie calculates that about $1.8bn of equity is required or, alternatively, around $2.8bn of asset sales. Meanwhile, Cromwell Property ((CMW)) is intending to sell assets while UR Westfield is considering its options.
In office, growth slowed to 2.4% in FY20 and valuations continue to lag the physical market, with rents in Sydney and Melbourne coming under pressure in the last two months. Yet JP Morgan is more constructive on the basis that rental changes are cyclical, tenant covenants are stronger and capital demand is firm.