A-REITs: Regulatory Uncertainty Clouds Residential

This story features MIRVAC GROUP, and other companies. For more info SHARE ANALYSIS: MGR

-Rising risk with investor housing
-Pressure from rising bond yields
-Sydney CBD becoming more up-market
-Can lower AUD boost office demand?
 

By Eva Brocklehurst

Since the Reserve Bank of Australia flagged its concern over investor activity in the housing market, uncertainty around future residential conditions has increased. The RBA is expected to announce measures to curb investor lending by the end of the year, although any tweaking of macro prudential arrangements is likely to be conducted by the Australian Prudential Regulation Authority. The current Financial System Inquiry is also a risk that is relevant to the Australian home loan market, with APRA being concerned about the credibility of internal capital models as a measure of financial strength. In this environment the residential Australian Real Estate Investment Trusts (A-REITs) are facing an uncertain outlook, in Morgan Stanley's opinion.

In this respect, Mirvac ((MGR)) has the greatest exposure to the investor segment of the housing market, predominately from its mix of medium and high density apartments versus land subdivision, as opposed to Stockland's ((SGP)) portfolio mix. Still, given the investor segment has been an influential driver of volumes, Morgan Stanley suspects changes could also affect Stockland. Moreover, if macro prudential regulations are introduced with a loan-to valuation-ratio component this could also affect first home buyers.

BA-Merrill Lynch too expects that macro prudential measures to curb house prices, and investor exuberance, may be on the way in Australia. A-REITs were down in line with the broader market over September, selling off as bond yields rose on expectations the US Federal Reserve would begin contemplating rate rises. Those A-REITs favoured for their yield exposures were the worst performers, such as BWP Trust ((BWP)), Investa Office ((IOF)), Dexus Property ((DXS)) and Charter Hall Group ((CHC)). The sector is trading in line with Merrills' valuations, suggesting it is fully valued. The sector offers an implied total return of 8.2% on the broker's estimates. In a rising US rate environment, historical data suggests to Merrills an underweight position in Japan & Australia is the safest play, with market weight for Hong Kong & Singapore and overweight reserved for China & India.

On the retail scene, UBS has conducted a review of the Sydney CBD's planned transformation, observing the landscape will change over the next two years with a pedestrian strip in George St from Bathurst to Hunter Streets and the construction of light rail planned for April 2015. This is expected to transform landlords including Mirvac, Charter Hall, Investa Office, Dexus and Lend Lease ((LLC)), which will benefit fro greater accessibility and exposure to office and retail offerings. Rents in the area may also benefit but are not expected to surpass the rents from Pitt St Mall, which the broker observes is among the top 10 most expensive retail strips globally by rent per capita.

More international retailers are descending on the CBD and luxury groups are eager to secure prime locations. Sydney's CBD is highly concentrated and UBS observes luxury brands desire to be adjacent to existing retailers with similar cache, such as Louis Vuitton and Prada, while fast fashion is intent on obtaining street frontage. The broker's feedback suggests landlords are favouring offshore tenants over established domestic retailers, which are being displaced. Rents appear well supported but, despite the demand for retail space, UBS is wary about growth. Office landlords are also becoming more active in maximising space. UBS expects existing food courts such as Australia Square and MLC will undergo a re-positioning towards more up-market eateries.

In the case of office space, the broker ponders whether the lower Australian dollar will boost white collar employment and hence office demand. The current supply of office space reflects subdued employment growth while office landlords are seeking to develop more efficient space. UBS economists forecast a modestly improving trend in jobs growth and the recent drop in the currency should help in terms of office demand. Still, the broker believes this may take some time to play out, with the vacancy rate yet to peak. The Australian dollar also needs to sustain its lower rate. Hence, while the broker does not expect office fundamentals to deteriorate, CBD office markets are approached with caution.

UBS maintains a preference for retail A-REITs, particularly non-discretionary, over CBD office and has moderated its view on residential markets, given the uncertainty over pending forms of macro prudential tightening. UBS economists note that the latest housing data suggests a moderation in the pace of lending, which should provide a little comfort for the RBA. Key picks are Goodman Group ((GMG)) as its business model and investment themes are robust, Federation Centres ((FDC)) as it continues with developments and syndicate acquisitions and remains on track to deliver 7-8% growth in FY15/16. The broker has Sell ratings Dexus, Investa Office and CFS Retail ((CFX)) on relative valuations. The broker remains underweight office A-REITs in a REIT portfolio context but, given the recent pull back, acknowledges there is less conviction in the Sell ratings on Dexus and Investa Office.
 

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