Australia | Sep 12 2012
– Longer-term upside for listed residential developers
– Some caution on office market outlook seems warranted
– Office average income growth to decline
– Westfield not a buy relative to US peer Simon
By Chris Shaw
With reporting season now behind the Australian REIT (A-REIT) sector, BA Merrill Lynch has conducted an overview, looking at reporting standards, valuations and return profiles for stocks in the sector.
As a sector, A-REITs offer a relatively defensive, inflation-hedged investment, BA-ML noting real estate has a fundamental value that should act as a genuine store of wealth in any downturn. With most rent structures factoring in annual increases, there is also a natural inflation hedge.
REIT structure can either be as a standalone unit trust, which is externally managed, or via a stapled security, which is managed internally. There are advantages to the latter including a lower cost of capital.
Growth for A-REITs can be internally through rent increases, tenant upgrades and the redevelopment of existing properties. External growth can be achieved via acquisitions, fund management and development activities.
BA-ML notes A-REITs offer some benefits to investors relative to direct property, including the ability to access higher quality assets and lower barriers to entry for investors, as well as professional management teams.
Following the GFC, balance sheets in the A-REIT sector have been recapitalised and offshore and non-core assets have been sold. In the view of BA-ML this leaves the sector in a strong position, as growth should be around the 3% level and yields of 6% are forecast.
These forecasts compare to an annual average return for A-REITs of 7% over the past 20 years, which represents marginal underperformance relative to the broader Australian equity market's return of 8.9% over the same period.
BA-ML notes there is generally a positive correlation between bond market returns and A-REIT performance, as periods of falling interest rates tend to support outperformance by A-REITs given higher yields on offer. A-REITs cover retail, office, industrial and residential market exposure, with retirement a smaller sub-sector with limited exposure among listed property plays.
A growing trend among A-REITs has been to report in terms of Funds From Operations (FFO), though BA-ML notes this approach creates some issues as not all companies adopt the same standards in such an approach.
Alternatives such as earnings per share (EPS) remain but BA-ML suggests cash is king for A-REITs as the most important measure for the sector is the amount of cash generated by the business. BA-ML notes Discounted Cash Flow (DCF) and Net Asset Value (NAV) are among valuation methods adopted throughout the sector.
With respect to dividend yield, spreads suggest to BA-ML the A-REIT sector is well placed to potentially trade at or above Net Tangible Assets (NTA) for the remainder of the year given interest rates are falling. As the cost of debt is now lower, BA-ML suggests A-REITs may now look to become acquirers of assets.
At present, A-REITs own more than $70 billion in assets managed on behalf of other investors, including non-residential development pipelines of more than $34 billion. According to JP Morgan, at present the market is bullish on the implied value being placed on development value creation and funds management operations for the likes of Westfield Group ((WDC)), Goodman Group ((GMG)) and Charter Hall Group ((CHC)) but the market is bearish on implied carrying value for the land banks of residential developers.
This is despite signs of improvement in residential markets, JP Morgan noting demand is rising in New South Wales, Victoria is returning to long-term average levels, Western Australia has a positive outlook and Queensland is recovering from a low base.
Residential settlements for listed developers fell 7% in the year to June 2012 relative to the year before, but JP Morgan notes this compares to a decline in national building approvals for the same period of 11%.
This implies the listed developers are taking market share, JP Morgan estimating listed developers have grown market share to 14.7% in FY12 from 11.3% in FY07. For JP Morgan this suggests there is value among the residential developers, the broker's preferred exposures among active REITs being Stockland ((SGP)), GPT ((GPT)) and Mirvac ((MGR)). This reflects the view returns for listed developers will improve through FY14 and FY15 as sales pick up and as impaired sales are reduced.
Looking more closely at the office market, UBS sees reason to be cautious given the likely impact of structurally higher levels of incentives and the implications for payout ratios relative to FFO reporting and acquisition strategies.
FFO replaces distributable income for many REITs and sees amortisation of fit-out incentives, cash incentives and leasing commissions added back to net profit.
For the Australian office sector at present, UBS notes average incentives for existing portfolios are well below the market level of incentives, but a longer period of higher incentives is expected in the Sydney and Melbourne markets.
Under such a scenario, UBS suggests payout ratios for the likes of Commonwealth Property Office ((CPA)) and Dexus ((DXS)) where targets are to payout 70-80% of FFO may come under pressure. This is particularly the case if leasing and maintenance capex remains at elevated levels for the medium to longer-term.
Alternatively, UBS points out if current dividend payout ratios were maintained, the payout ratio of free cash flow of AFFO with 15% incentives range from 97% for Investa Office ((IOF)) to 115% for Commonwealth Property Office. This means office REITs will be paying distributions not covered by free cash flows.
In UBS's view, the easiest way for the office REITs to dilute this impact is to acquire more assets, particularly new properties with extended average lease expiries. This throws up one problem from a management perspective in that landlords are likely to struggle to add value to the asset in the interim, though UBS notes such properties will likely improve the average quality of a portfolio.
JP Morgan has also looked more closely at the office sector and forecasts lower average income growth of 2.5-3.0% in FY13, down from the more than 3.3% achieved in FY12. While GPT and Dexus achieved strong growth in FY12, both are expected to deliver lower returns in the coming year, this given higher vacancies and large exposure to a soft Sydney CBD market.
Despite this JP Morgan recently upgraded Dexus to a Neutral rating from Underweight, in part given an increasingly attractive valuation relative to the sector. The other attraction for JP Morgan is Dexus has a growing funds management business that is likely to be supportive of valuation going forward.
With respect to the adoption of FFO reporting, JP Morgan notes five of the seven office landlords now use such an approach, but there are some differences in methodologies being used. This makes comparing performance harder, leading JP Morgan to suggest some uniformity of approach over time would be well received.
Having reviewed the portfolios of the seven office REITs under coverage, JP Morgan rates GPT, Stockland and Mirvac as Overweight, is Neutral on Dexus, Investa Office and Australand ((ALZ)) and rates Commonwealth Property Office as Underweight.
Further analysis of FFO has been undertaken by Goldman Sachs in determining whether the significant FFO multiple discount for Westfield Group implies a buying opportunity relative to US peer Simon.
While both have similar business models, Simon has outperformed Westfield by more than 90% since the end of 2009, but even accounting for this relative performance Goldman Sachs still doesn't see a relative buying opportunity in Westfield in the short-term at least.
One reason is Westfield has a higher reliance on non-rental earnings and offers subdued near-term upside from development capacity. As well, Westfield is dealing with weaker Australian macro factors, while Simon offers greater upside in terms of occupancy costs.
Simon also appears to offer greater internal growth potential, Goldman Sachs estimating the group can produce annual same store net operating income growth of 4% over the next two years. This is 120 basis points above the forecast for Westfield Group. This reflects delays to Westfield Group's growth profile, which should continue at least until assets sales impact on FY13 results and the group can re-accelerate its development pipeline.
Given this outlook, Goldman Sachs suggests any contraction in the relative multiples of Simon and Westfield Group is unlikely to occur in the shorter-term.
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