Are Concerns About A-REITS Overdone?

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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

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.

Office

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.

Specifically, Macquarie expects rent declines in office will drive earnings down for Dexus and Mirvac while growth expectations are retained for Charter Hall Group and Goodman Group ((GMG)).

Media speculation suggests Blackstone is considering a move on a large Australian A-REIT, potentially Dexus, and JPMorgan assesses office valuations are unduly bearish. The broker has upgraded Dexus to Overweight and highlights that Mirvac is trading well below fundamental valuation, as is indeed GPT.

The broker believes investors are being paid a substantial risk premium to hold the shares and the risks to the commercial office segment are overstated. Moreover, JP Morgan envisages a scenario where investors deploy capital earlier in Australia compared with other jurisdictions.

Less risk in Australia also implies less outward shift in capitalisation rates (ratio between income and market value of an asset), particularly for prime assets in Sydney and Melbourne. Equity markets currently imply these rates will stabilise at 6-6.5% and CBD office asset values will fall -20-25%.

In the event of M&A, JPMorgan would typically expect premiums to the current prices of around 25-30% for large vehicles with heavy office exposure. This would be well above the historical premium of 12.5%.

Long Duration Alternatives

Goldman Sachs has analysed the benefits of long WALE (weighted average lease expiry) A-REITs, which have materially outperformed since 2018. A key trend in the last reporting season was these alternative A-REITs experiencing minimal impact from the pandemic. Moreover, in a low interest-rate environment, the relative attractiveness of those with long WALE exposure has increased.

This has led to asset value appreciation and increased demand from the direct property market. These A-REITs have defensive characteristics including long lease terms to essential services with minimum expiries over the near term. There are also strong rental escalations and government support to operators.

Rent relief, as opposed to retail, has been minimal. Hence, because of relatively lower debt costs and gearing, Goldman Sachs estimates Charter Hall Social Infrastructure ((CQE)), Arena REIT and Waypoint REIT ((WPR)) have ample capacity to add debt. The broker retains a Buy rating for CH Social Infrastructure and Waypoint, given secure income streams and the liquidity to pursue attractive investment opportunities.

In the case of Arena REIT and CH Social Infrastructure, the concerns around the child care sector and operator ability to pay rents have led to them underperforming long-lease peers and the broker believes these concerns are overdone. Childcare is a critical piece of infrastructure in returning people to work.

Meanwhile, Waypoint, with a focus on service station assets that are deemed essential, is not expected to experience disruptions to rental collections. The acquisition pipeline and transaction capabilities also provide avenues for growth.

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