A-REITs Show Earnings Resilience

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 – Australian REITs underperformed broader market last week
 – Interim earnings for the sector proved resilient this reporting season
 – A-REITs more focussed on shareholder returns
 – Equity brokers update their preferred exposures

By Chris Shaw

For the week ending February 24 the Australia REIT index rose 0.3%, which was less then the 3.2% gain booked by the broader market. At current levels, BA-ML estimates the sector offers an average implied total return of 15.3%, of which average yields make up around 6.5%.

In the view of BA-ML, interim earnings for the sector were resilient, as most companies maintained previous guidance for the full year despite what in some cases had been a tough six months to the end of last December. 

Morgan Stanley reached a similar conclusion, noting while there were a number of revisions to sector earnings forecasts, these were of much smaller magnitude than for the wider market. 

An assessment of earnings results allowed Goldman Sachs to take away a number of points on both a macro and stock specific basis. One of the most important themes to emerge was in relation to the cost of debt, as swap curves have declined significantly in the past six months.

As GS notes, this allowed a number of REITs to take out forward hedging on the their debt book, so lowering overall debt costs and boosting earnings in the process. In contrast, at the top line net operating income growth was weak at most levels, though growth in the retail sector remains well above that of office and industrial rent growth.

In GS's view this implies for the retail sector the downside risk to net operating income and earnings from weaker leasing spreads appears quite limited. The Industrial net operating income growth outlook appears modest, while catalysts across all asset classes are lacking in the broker's view. 

This leads GS to suggest a strategy for the Australian REIT sector of preferring retail exposures which appear cheap relative to asset values, especially where there is also solid rent and earnings per share growth on offer.

Another trend identified by GS during the December half year was a closing of the gap between on-balance sheet leverage and look through gearing. As REITs divest offshore investments to focus on core assets, this trend is expected to continue.

Post the interim reporting season, Goldman Sachs has made only minor changes to earnings estimates on average, though this has been largely offset by an increase in average distribution expectations. 

This is in line with the Morgan Stanley's view REITs have a focus on shareholder returns, as evidenced by moves to dispose of non-core assets. This is boosting the popularity of share buybacks, which in part is due to a lack of accretive growth opportunities across the sector.

A little disappointing to Morgan Stanley was less in the way of cost initiatives than the broker had hoped, as for example management expense ratios have not come down much over the past 6-12 months.

In the retail sector, Morgan Stanley sees signs of a slowdown, taking the view pressure on leasing spreads is likely to become a risk to long-term growth. In the office market headwinds such as redundancies in large corporations mean a challenging outlook, while the outlook for the residential sector remains subdued in the broker's view.

Among the developers, Morgan Stanley suggests Goodman Group ((GMG)) has continued to execute on its strategy, while the market's focus on Lend Lease's ((LLC)) Barangaroo project means the stock is likely to stay range bound until this project is delivered.

Looking forward, Morgan Stanley expects the Australian REIT sector to outperform unless the market rally continues. This is a reflection of the solid yields and relatively defensive earnings on offer.

Morgan Stanley retains a preference for business exposure over consumer exposure, so the office sector is preferred. Among the large cap plays the preferences are Goodman Group, Westfield Group ((WDC)) and Lend Lease, given superior growth profiles not yet reflected in respective share prices.

At the smaller end of the sector Morgan Stanley prefers Charter Hall Retail ((CQR)) and Investa Office ((IOF)). BA-ML's Buy ratings across the sector are Dexus ((DXS)), Mirvac ((MGR)), Stockland ((SGP)), Westfield Group, Astro Japan Property ((AJA)), Challenger Diversified ((CDI)), Centro Retail ((CRF)), Charter Hall Group ((CHC)), Cromwell Corporation ((CMW)), FKP Group ((FKP)), Investa Office and Peet and Company ((PPC)).

Goldman Sachs rates Charter Hall Group, Stockland, Westfield Retail ((WRT)), Goodman Group and FKP Group as Buy, while rating GPT Group ((GPT)) and Investa Office as Sell. 

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