Plunging Bond Yield Supports A-REIT Value

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-Spread to 10-year bond supportive
-Westfield Group underperforms
-Peak forming in residential?
-Vacancy outlook weak in prime office
-Favourable outlook for industrial
 

By Eva Brocklehurst

Australian Real Estate Investment Trusts (A-REITs) underperformed the broader market in May but this follows a substantial outperformance in April. May's underperformance for the S&P/ASX 200 A-REITs relative to the index was influenced, in part, by Westfield Group ((WDC)) finishing the month down 2.3%, following its proposed restructure. The Scentre proposal was voted on during the month and this meant many investors stayed on the sidelines.

UBS observes the sector's dividend yield spread to the Australian government 10-year bond is generally supportive of A-REIT valuations and this should provide a buffer against these softening fundamentals, such as weaker consumer confidence and negative news flow from the federal budget. Soft retail sales could also prolong a period of negative leasing spreads and impact operating income growth for those exposed to the discretionary retail sector. In this camp are Westfield Retail ((WRT)) Westfield Group, CFS Retail ((CFX)) and GPT ((GPT)). UBS prefers non-discretionary retail sectors driven by the resilient nature of food and retail services. In this case preferred retail A-REITs are Federation Centres ((FDC)) and Charter Hall Retail ((CQR)).

BA-Merrill Lynch believes the A-REIT sector is expensive, implying a total return of 6.3% on the broker's estimates. The broker also notes Westfield Group continues to underperform, as while the vote on the proposed restructure was passed, the accompanying Westfield Retail vote on the Scentre proposal was controversial and deferred for 10-14 days to allow shareholders to consider new information. This new information was confirmation that Westfield would pursue a de-merger of its Australasian business regardless of the outcome of Westfield Retail's vote.

Turning to the property and housing markets, Merrills finds evidence that a peak is nearing. House price gains have slowed, auction clearance rates have eased and building and housing finance approval growth has lost some momentum. Deteriorating affordablity and weakening consumer confidence, as well as high levels of indebtedness, are all contributing factors. Still, the broker does not expect sharp declines in the sector and considers the easing back of auction clearance rates as indicative of a re-basing of vendor pricing expectations and a healthy stabilisation in the sector.

Retail sales improved in April across key shopping centre categories, suggesting momentum is building. While accepting one month's data does not dispel winter's gloom, JP Morgan notes NSW continues to outperform, with sales up 6.1%, while Western Australia is more anaemic, with 2.7% growth in retail sales in April. GPT and Westfield Retail stand to be the beneficiaries of stronger sales growth in this respect because of their higher weighting in NSW

In the office segment, Deutsche Bank expects Sydney's CBD vacancy rates will now peak later than previously thought, and at higher levels. The broker's forecasts show vacancies peaking in FY16 at 13.0%, with prime assets peaking at over 16%. The broker remains Underweight on Investa Office ((IOF)) and Dexus Property ((DXS)) versus the broader A-REIT sector. 2015 and 2016 are both likely to show an increase in supply.

This is normally accompanied by increased take-up as tenants move to new, expanded, premises. The supply cycle differs this time in that tenants who have pre-committed to new developments are taking, in aggregate, less space than they currently occupy. Prime grade stock looks to be the worst hit on this occasion. Taking into account new supply to December 2015, Deutsche Bank estimates the remaining pool of prime tenants would need to expand by 17% just for vacancy rates to remain at current levels. Moreover, any trading up and moving to central locations from the suburbs would involve groups of tenants that are likely to be fairly price sensitive.

Expanding on this theme, Morgans prefers those with exposure to offices with long-weighted average lease expiries, such as GPT and Cromwell Property ((CMW)), given the soft demand from tenants and increased supply in some markets.

Morgans also believes good quality industrial property has a favourable outlook in the near term, with demand from internet retailers and businesses looking to upgrade logistics infrastructure. Herein lies a preference for BWP Trust ((BWP)) and Industria ((IDR)). On the retail side, Morgans prefers Federation Centres while the preferred residential play is Stockland ((SGP)). The broker recently initiated coverage on 360 Capital Office Fund ((TOF)), which offers a focus on suburban office markets. The stock pays an attractive quarterly distribution with a yield of 8.5%.

Morgans expects most A-REITs will pay increased distributions in FY14, with the average sector yield attractive at around 6.0% versus the broader market at around 4.5%.

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