Oz Property Should Ride Out The Storm: S&P

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Analysts have been examining the prospects for the Australian property market in the face of toughening macro conditions, and the forecast is for clearing skies with pockets of drizzle and the prospect of buybacks.

-S&P sees no major calamities for Australia’s property sector
-RBA cash rate forecast to peak near 2.8% in 2024
-Australian banks considered well positioned
-Jarden and Morgans pick property winners and losers
-Morgan Stanley says time is ripe for AREIT buybacks

By Sarah Mills

S&P Global Ratings conducted an Australian Property Spotlight webinar this week and says given Australia’s low unemployment is not expected to shift markedly over the next two years, the sector should hold up well.

Key Macro Forecasts

The webinar primarily examined the macro environment, before drilling down to property sub-sectors.

S&P Global expects the Australian cash rate should rise from 1.35% now, to 2.5% in 2023 before peaking at 2.8% in 2024 and then easing to roughly 2.5% in 2025.

Australia’s real GDP growth is expected to bottom just above 3% in 2022 before recovering to roughly 5.5% in 2023 after which GDP is expected to ease to roughly 5% in 2024 and 4.8% in 2025.

Housing prices are expected to fall in an orderly manner (meaning S&P is not on board with the many forecasts for a -10% to -20% average price fall next year).

S&P says the main cause for concern in the near term is that consumer sentiment indicators have fallen sharply in 2022, but notes business confidence has held up much better, albeit gyrating every few months.

Residential Property Forecasts

In a nutshell, S&P expects Australian residential property price growth to fall to roughly -15% in 2022 before embarking on a reasonably swift recovery, rising 15% in FY23 to hit roughly 7% by mid-2024.

If S&P is correct, the price nadir is almost behind the sector. Also, with most forecasters in Australia predicting -10% to -20% falls in housing prices over the coming two years, S&P's projections are significantly more positive.

S&P says supporting factors for residential property include:

– a recovery in immigration, S&P citing a backlog of 1m visa applications;
– historically low unemployment rate (expected to continue for two years); 
– the fact that while prices are coming off the boil, the cost of construction is rising, constraining new supply; and
– millennials, which comprise 21.5% of the population are on the hunt for houses, looking for nests as they move into the 29-34-year age bracket.

On the flipside, S&P notes that a big contributor to a recent decline in business sentiment has been the rising cost of construction, which has been squeezing margins, and believes this will likely keep a lid on euphoria.

A Tale Of Two Cities For Retail Landlords

When it comes to big retail landlords, S&P agrees with most analysts the outlook for discretionary sector (retail strip shopping) is more pessimistic than for the non-discretionary sector (suburban malls).

The latter are already returning to normal trade notes S&P, but the slowdown in the CBD office market post-covid as the work-from-home theme persists is hurting CBD retailers in particular.

Commercial and Industrial Property another story of division

Rising debt costs from rate rises and expansion of the credit spread is a growing feature of the AREIT sector.

S&P expects the commercial and industrial AREITs should be able to manage the rising costs of debt given their high proportion of fixed-rate debt and smooth maturity profile.

The agency says only an estimated 14% of debt is expected to mature over the next two years, making refinancing manageable.

S&P expects landlords that enjoy fixed CPI-linked rents should prove defensive while commercial landlords with mixed office retail are expected to pay sizeable tenant incentives to attract occupancy in the CBD.

Industrial REITS, once often beneficiaries of covid, are unlikely to escape the rising rate environment unscathed, says the agency. But S&P notes the majority have considerable headroom within debt covenants.

Weaker REITs could endure a -30% slump in property prices, says the agency, while the strongest could ride out a -72% fall.

Meanwhile, inflation should eventually translate into higher rents.

Build-To-Rent Sector

There has been a lot of talk for decades about the “build to rent” sector, but to date Australia has lagged the US and Europe.

S&P suspects this may be an area of movement over the next few years.

Given tenants are expected to pay a premium for the security of a long-term lease, it should attract investor interest.

Already there is movement in the Australian market and S&P confirms the time is ripe.

Banks Expected To Be Just Fine

Meanwhile, Australian banks with their strong earnings and capital bases are likely to weather the short-term decline with ease. S&P retains its Stable to Positive outlook on the sector.

While some heavily leveraged borrowers may struggle, these represent roughly 1% of total borrowings, notes S&P, and credit losses are likely to return to pre-pandemic levels.

Writing new loans may be a different matter as rising interest rates unnerve consumers, and the shortage of housing due to rising construction costs limits growth.

S&P expects credit growth will slow from 8% in FY22 to 5% over two years.

The low unemployment rate is likely to stay low for two years, meaning repayments should stay on track.

Just to be sure to be sure, S&P notes Australians have a long history of favouring mortgage repayments over discretionary spending, and have been busy squirrelling money away during covid, just in case.

The wildcard would be a sharper than expected downturn but most analysts doubt this, with only a few lone voices ringing the worst (although China is, apparently, expecting a global asset crash within the next two to three years). 

There are plenty of clouds circling the horizon but S&P remains sanguine (hopefully not a reiteration of their sanguine approach during the GFC). The agency notes that even should new loan-growth deteriorate, the banks should benefit from rising interest rates, which should improve margins.

Most are also planning to write new ESG-related loans.

S&P says non-banks are more likely to move into higher debt-to-income lending as banks retreat. Meanwhile, S&P says lenders mortgage insurers – the high-risk financiers – are tracking well after being place on watch in 2020.

LMI claims rose in the early days of covid before rallying and S&P expects return on equity should return to the 9% historical average.

S&P also expects residential mortgage backed securities should survive its stress test scenario, which assumes 30% of mortgages are under stress.

Jarden and Morgans Lay Their Bets

Jarden and Morgans both conducted recent reviews of AREITs.

Jarden notes consensus earnings for AREITs have eased with FY23 consensus EPS/FFO forecasts falling to a 7.9% weighted average. The broker also points out the growth prospects for AREITs do diverge sharply.

Overall, Jarden expects AREITs will continue to enjoy superior growth and could deliver earnings surprises.

The analyst forecasts the cap rate will expand to 30-40bps in FY23 but concedes this may prove optimistic.

Jarden says balance sheets are looking good but suspects growth will come through asset recycling rather than equity or debt. The analyst expects acquisitions will slow, believing it will be hard to “stack up acquisitions at scale” and given development margins are under pressure.

But it does spy opportunities for sector consolidation at present valuations.

When it comes to rental growth, childcare, Long WALE (weighted average lease expiries), retail and manufactured housing estates appear to offer the best safe harbours, says Jarden, thanks to their inflation-linked leases.

Jarden says the slowing in tenant performance is likely to drag, particularly in retail. The broker also takes a cautious approach to office REITs. Growth in storage is forecast to slow.

Approaching the reporting season in August, the analyst favours Scentre Group ((SCG)), Vicinity Centres ((VCX)), Shopping Centres Australasia Property Group ((SCP)), Homeco Daily Needs REIT ((HDN)) Charter Hall Retail REIT ((CQR)), National Storage REIT ((NSR)), Abacus Property Group ((ABP)), Goodman Group ((GMG)), Ingenia Communities Group ((INA)), Lifestyle Communities ((LIC)),  Centuria Industrial REIT ((CIP)) and Charter Hall Long Wale REIT ((CLW)).

Morgans Has Its Say

Morgans says the market is factoring in the likelihood that cap rates will expand, but counters the REITs ability to grow rental income through inflation-linked leases or to value-add via development and leasing should partially offset this.

The broker also appreciates the sector’s historical performance as an inflation hedge. Morgans expects fee income may be hit by lower asset values and transactional activity, which may hit fund managers.

This analyst likes niche sectors with good underlying cash flows underpinned by strong tenant covenants, sustainable distributions and growth options.

“This includes REITs exposed to pubs; social infrastructure; convenience retail and industrial/logistics,” says Morgans. 

“We expect the favourable tailwinds for industrial/logistics assets will remain n place with significant demand for the asset class given the growing shift to e-commerce and focus on supply-chain resilience.”

Morgan Stanley Says The Time Is Ripe For Buybacks

Morgan Stanley speculates that buybacks may represent the best capital allocation option for REITs given they are trading at an average -21% discount to net tangible assets.

While conceding that astute developments are likely to yield windfalls for investors, the analyst doubts commercial developments will be able to retain their historical margins of 25% to 30%.

Instead, the broker suggests buybacks would provide value-add certainty and a margin of 17%. Morgan Stanley estimates that for every $100 a REIT spends on a buyback, it would gain $117 in return. 

The analyst considers this very attractive given the rate’s proximity to the 25% to 30% historical margin, and given the fact that a buyback carries fewer leasing, construction and timing risks, particularly in a higher interest rate and input-inflation context.

In support of this view, Morgan Stanley points to the fact that Sydney and Melbourne office cap rates are at historical lows, and that rates are rising as the cap rate differential compresses. 

The analyst has observed the market cap rate has broadly tightened by roughly 75bps between the dates of construction commencement and project completion.

This, says the broker, suggests roughly half of the historical 25-30% margin may have been attributable to market forces, which are, of course, looking a touch less optimistic.

However, Morgan Stanley reassures investors that projects already under way should deliver the traditional 25% margin given most costs have been locked in and profits assured through agreements with capital partners. 

The most likely buyback contenders are Mirvac Group ((MGR)), GPT Group ((GPT)), Dexus ((DXS)) and perhaps Scentre Group, says the broker.

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