A-REITs Outperform But There’s More To Come

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

-Residential, regional retail preferred
-Sector fully priced but can rally still
-More narrowing of cap rates priced in

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) continue to outperform the rest of the market, assisted by record low 10-year bond rates. UBS finds it easy to imagine the A-REITs will outperform again this year on the back of low global yields and downward pressure on inflation from lower oil prices. Add in cheap finance, a lower Australian dollar and potential corporate activity and this bullish position fast becomes crowded.

The broker highlights the fact the sector is trading at a 2.8% premium to valuation while acknowledging, if the long bond remains at current levels, there is further room for a sector rally. By segment, UBS prefers residential and regional retail over industrial, non-discretionary retail and office. The main change to the broker's recommendations is the growing conviction that the residential cycle will be stronger for longer, with a pick-up in discretionary retail. Hence, UBS favours the residential segment this reporting season, reflected in stocks such as Mirvac ((MGR)) and Stockland ((SGP)). The broker expects FX benefits will support Westfield ((WFD)) and Scentre Group ((SCG)) over the office A-REITs.

The sector is fully priced in JP Morgan's opinion too. It is trading around 6.0% above the broker's average price targets with the average distribution yield at record lows of 4.8%, despite still exceeding the long-term bond rate by 240 basis points. Last month, in large cap stocks, outperformance was led by Dexus ((DXS)), Novion ((NVN)) and Westfield. Notable underperformers were Lend Lease ((LLC)), Hotel Property Investments ((HPI)) and Astro Japan Property ((AJA)). Over January there were both acquisition and equity raising activities with two major asset sales, while two portfolios are also being marketed, from Mirvac and US-listed Equity Commonwealth. JP Morgan's top pick remains Mirvac, which is trading at a perceived 6.0% discount to fair value.

Morgan Stanley remains attracted to the industry because of the positive earnings momentum, as debt costs step lower and multiples expand in response to record low bond yields. Mirvac and Stockland have underperformed the rest of the sector in the past six months, in the broker's opinion, despite the improved fundamentals for the residential sector. Morgan Stanley expects the latest rate cuts could act as catalysts to reverse this underperformance. An improving Sydney office market could provide the scope for upside while retail sales figures suggest there will be little change to negative re-leasing spreads in that arena.

Subdued growth for FY15 is forecast for SCA Property ((SCP)) as the majority of the Woolworths ((WOW)) rent guarantees rolled off in December 2014. However, Deutsche Bank expects a rebound in FY16, driven by specialty vacancy rates falling to 5.0%. The broker expects Cromwell Property's ((CMW)) growth will largely be driven by the acquisition of Valad Europe while Charter Hall Retail's ((CQR)) transition to a domestic vehicle in FY15 will be weighed down by the dilution from offshore asset sales. The broker expects first half earnings will be slightly lower because of the rolling off of higher returning contributions from Europe. While Charter Hall Retail has guided to underlying Australian growth of 8.0% or more the broker estimates around 3.0% of this relates to he redeployment of offshore sales proceeds.

Those A-REITs best placed to positively surprise in terms of lower funding costs are Investa Office ((IOF)) and Hotel Property, in Goldman Sachs' view. Falling petrol prices and cycling of new government legislation have resulted in strong gaming profitability in Queensland where Hotel Property's hotels are located.

Goldman Sachs also observes that over the last 12-18 months, traditional direct property asset classes such as office, retail and industrial, have witnessed an influx of demand from institutional capital, both from locals and from offshore. The broker highlights that 2014 was a record year in terms of transaction value. The flow-on effect of the strength of direct markets and the appetite for traditional property in Australia has resulted in the compression of yields and capitalisation rates – the ratio of producing income to asset value. In the case of office and retail, and Goldman notes this cap rate compression has occurred without any underlying income growth.

The broker believes cap rates can narrow further, and that the equity market appears to be pricing this in, with all stocks ex Dexus trading at implied cap rates that are lower than those stated back in June 2014. Goldman believes another 25 basis points of official rate cuts are on the table in August after this month's cash rate reduction to 2.25%. Hence, A-REITs that may positively surprise in terms of lower funding cost include Investa, Charter Hall Retail and Hotel Property, all at the lower credit quality end of the spectrum.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms