A-REITs Still Finding Solid Support

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Brokers suggest A-REITs are likely to continue finding support amongst the global investment community, given an increasing need for annuity income and scarcity of investment-grade real estate.

-Valuations and relative performance main reasons for A-REITs appeal
-Most concerns centre on the retail segment
-Capital markets still viewing Sydney's office segment favourably
 

By Eva Brocklehurst

May was a strong month for Australian real estate investment trusts (A-REITs) as they outperformed the broader ASX 200 equities index as well as most major global REIT indices, with the exception of the US.

Shaw and Partners notes, over the month, yields tightened and geopolitical issues were in focus as investors took refuge in safe havens, such as the US, and defensive stock, such as REITs.

The broker believes A-REITs screen cheaply relative to direct real estate investment in Australia and the M&A cycle has not yet reached its conclusion.

Hence, the predictability of earnings and increasing need for annuity income, as well as an increasing scarcity of investment-grade real estate, should provide support for good-quality A-REITs.

Shaw and Partners' sector forecast total shareholder return is 7.5%, including a 5.1% yield. Support in the short term is expected to emanate from the reinvestment of proceeds from the Westfield transaction, along with most A-REITs going ex-dividend in late June, and lower 10-year bond yields in the US and Australia.

Morgan Stanley agrees the international investment community finds A-REITs relatively attractive, although concerns are heightened regarding the residential and macro environments. This is the broker's conclusion after meetings with investors in the US, Europe and Asia.

Valuations and relative performance were cited as main reasons for the increase in appeal, while the biggest debate centres on retail. The discussions with investors underscored the broker's preference for office over retail and, within retail, self-help over perceived quality and developers over aggregators.

The broker also highlights that many investors were surprised by the level of capital expenditure required to maintain sales growth, or conversely the deterioration in sales growth in retail assets that are left undeveloped.

Morgan Stanley highlights they were also interested in the momentum in the Lend Lease ((LLC)) development & investment management businesses.

Retail

Morgan Stanley observes the use of company voluntary arrangements (CVA) to negotiate store closures and rent reductions, a UK insolvency process, is accelerating. The process allows a company to review and restructure leasing obligations.

If 75% of all creditors vote for, and less than 50% of non-connected investors vote against, then the company's proposal is approved and implemented. Morgan Stanley observes this not only adds uncertainty to current lease commitments but is starting to reshape future income visibility.

While this CVA legislation does not exist in Australia the broker also observes recent trends in the UK reveal a global shift in the balance of power towards tenants and away from landlords.

Internationalisation of retail could mean such methods of dealing with lease commitments flow through to Australian shopping centres.

The broker finds growing evidence of Australian retailers successfully negotiating store closures/rent reductions such as Sumo Salad and Specialty Fashion ((SFH)).

Therefore, increasing variability in specialty lease structures could change the value proposition of shopping centres and signal lower, more volatile and less transparent operating income growth as well as require much higher capital expenditure.

Consequently, Morgan Stanley is cautious regarding shopping centres and prefers Vicinity Centres ((VCX)) and Stockland ((SGP)) over both Scentre Group ((SCG)) and Mirvac ((MGR)) if investors need exposure to shopping centres.

Office

Mirvac has exercised its pre-emptive right to acquire a 50% stake in 275 Kent Street Sydney for $721.9m and will assign the rights to an existing capital partner.

The company sold the stake in 2014 for $435m, retaining the remaining 50%. The 2018 sale price implies a 30% premium to book value at a yield of around 3.9%, in Macquarie's calculations.

Given Sydney office rents have increased by around 40% since Westpac ((WBC)) signed a 15-year lease across 75% of the building in 2015, the broker suggests the acquirer has probably factored in positive leasing spreads in outer years.

While earnings leverage to improving Sydney office market is taking time to flow through to free cash flow, Macquarie believes capital markets are still viewing the segment favourably.

With upside risk to asset valuations the broker remains positively disposed to Sydney's office segment and retains Outperform ratings on Dexus ((DXS)), GPT ((GPT)), Mirvac and Charter Hall ((CHC)).

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