Value To Be Found In Defensive A-REITs

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Increased volatility in markets and downgraded economic growth expectations are a positive backdrop for defensive names among A-REITs. Brokers embark on a round of stock picking.

-Growing income, assets in office & industrials vs weak retail & residential segments
-Citi maintains its highest conviction in the funds management subset
-Brokers note some life left in office rental growth in Sydney, Melbourne
 

By Eva Brocklehurst

In 2019 the outlook for Australian real estate investment trusts (A-REITs) is segmenting, as retail and residential are under pressure while funds management, office and industrial are now the main areas favoured by brokers.

Citi forecasts a low-return year ahead for A-REITs with the main risk to the downside, including falling shopping centre values and the risk that capitalisation rates (income divided by value or purchase price) will start to rise in office/industrial segments.

While a synchronised commercial property downturn is not in the base case, the broker points out it could arise if global and domestic economic growth risks recede and there is a resumption of upward pressure on global security yields.

Citi expects investors to pay attention to a turn in the cap rate cycle, a major multi-year cyclical risk that has been flagged for the past two years. This is also considered to be the major driver of A-REIT returns, and there is growing evidence the cycle is ending, at least for certain types of listed property assets.

Macquarie suggests the increased volatility in equity markets, and the downgrade in growth expectations for both the Australian and US economies, is a positive for defensive stocks, such as A-REITs, as in times of rising volatility, historically these outperform the broader ASX.

Expectations for higher interest rate and yield curves have moderated as well. Earnings growth is expected to be relatively strong across the sector, which the broker notes at 4.8% compares to the broader industrials growth rate of 5.4%.

Offsetting factors are acknowledged, such as the outlook for retail assets, given structural challenges, and the weakness in the residential market, which will be a headwind for those exposed to both retail and residential segments.

Fundamental headwinds include reduced GDP growth and consumer spending. Debt spreads have also increased which will affect the cost of funding. The broker emphasises the strong negative correlation between the relative performance of A-REITs and the 10-year Australian government bond remains intact, and actually increased in 2018.

Defensive Names In Focus

CLSA asserts defensive stocks are back in fashion, and this means A-REITs should outperform. Office and industrials are expected to show both growing income and net tangible assets (NTA), although lower-quality retail will report weak rental growth amid risks of NTA downside.

This translates to expectations for fund managers such as Goodman Group ((GMG)) and Charter Hall ((CHC)) to report strong assets under management and earnings growth. Development completions and valuation uplift should be the main driver for Goodman Group, while Charter Hall should reflect growth from acquisitions. Ord Minnett concurs and upgrades Charter Hall to Accumulate.

Both CLSA and Ord Minnett upgrade Cromwell Property ((CMW)) to Outperform and Accumulate respectively, given increased funds under management and M&A potential. Ord Minnett upgrades Carindale Property ((CDP)) to Hold and SCA Property ((SCP)) to Accumulate based on valuation.

Despite a modest outlook for the sector, Citi asserts A-REITs will still offer opportunities over 2019 and has the highest conviction in the funds management subset. Therefore, exposure is warranted to both momentum, in terms of fund managers Goodman and Charter Hall, and value, in terms of Stockland ((SGP)), Abacus Property ((ABP)) and LendLease ((LLC)).

Growing opportunities among A-REITs exposed to residential markets are expected, as the broker asserts the Australian housing is not slumping and the stock prices are down -20-30% over 2018. Hence, Citi upgrades Stockland, LendLease and Abacus Property to Buy.

In contrast, CLSA downgrades LendLease to Underperform and reduces the multiples for all its business segments. The broker lowers residential settlement forecast for FY19-22 and reduces the company's construction/engineering margins for Australia.

Developers, Mirvac ((MGR)) and Stockland, are expected to be able to maintain FY19 guidance despite the fall in residential prices and volumes, although a skew to the second half is expected. Mirvac is also supported by its commercial development profits and office income growth.

Office

UBS has analysed office rents and the outlook is mostly positive. Sydney delivered 15% net effective rent growth in 2018 and the forecast for 2019 is 12%. In Melbourne the forecasts is 4% after 7% was delivered in 2018. This rental data supports the an upgrade of Dexus Property ((DXS)) to Neutral, as UBS is attracted to the low gearing and flexible balance sheet.

The broker had expected office supply would pick up more quickly and was, therefore, cool about rental growth expectations. Now, supply is expected to remain constrained amid another good year for rental growth in Sydney and Melbourne.

Citi agrees Sydney rental growth, while remaining a tailwind, is potentially moderating, although landlords will continue to experience positive rental growth on expiring leases. A move back to long-term averages in rental growth could represent some downside for office stocks.

Additionally, the broker suggests current valuations reflect some of the upside already and, thus, downgrades Dexus to Neutral from Buy. Ord Minnett also downgrades Dexus to Lighten based on the elevated multiples and Charter Hall Long WALE ((CLW)) to Lighten because of the reduced growth outlook.

The broker suspects market cap rates in Sydney are at risk of reaching an inflection point in 2020, because of slowing rental growth and a lack of affordability that may force decentralisation.

Retail

Citi is increasingly negative on retail and envisages share price downside of over -10% for this segment. The broker has a Sell rating for Scentre Group ((SCG)) and Sell ratings on all three small cap retail stocks, which are trading above NTA despite growing pressure on shopping centre values. This includes Charter Hall Retail ((CQR)), SCA Property and BWP Trust ((BWP)).

Ord Minnett downgrades Scentre Group to Hold, expecting its retail capitalisation rates to expand. Charter Hall Retail is also downgraded, to Lighten from Hold. While acknowledging structural headwinds in retail A-REITs, UBS retains a Buy rating for both Scentre Group and Vicinity Centres ((VCX)), assessing the valuation discount in the latter is too large to ignore.

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