A-REITs Renew Focus On Quality Assets

This story features CROMWELL PROPERTY GROUP, and other companies. For more info SHARE ANALYSIS: CMW

-Residential best performers
-Focus on better quality assets
-Tighter cap rates lead to lower rents?
-Regional mall pay-out ratios to fall?
 

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) completed eight straight months of outperforming the S&P/ASX200 in February. JP Morgan observes a select few were still running hot, including Aveo Group ((AOG)), Cromwell Property ((CMW)) and Mirvac ((MGR)). Residential stocks were considered the best performers in the reporting season and the broker retains a preference for this segment over the pure office and retail landlords. Hence, key picks are Stockland ((SGP)) and Mirvac, as both are leveraged to lower interest rates and a resilient housing market.

Portfolio repositioning is now a strategy that the sector is seen embracing, which involves getting out of lower growth assets and reinvesting or developing better quality assets. JP Morgan observes strong transaction activity and a narrowing of cap rates – the ratio of asset value to producing income – are underpinning this strategy, particularly in terms of developer margins. The broker highlights Westfield Corp ((WFD)) and Scentre Group ((SCG)), which have backed away from introducing new capital partners into their best assets and/or developments, possibly indicating further upside in asset values in the cycle is expected.

Goldman Sachs observes A-REITs made a strong start to 2015 and with interest rates set to remain lower for longer, and the spread of property yields to bond yields at an all-time high, demand for these equities should remain robust. The broker also notes positive asset revaluations are being driven by cap rate compression, while the cost of debt is falling, residential conditions remain robust and the organic growth outlook is muted. Of fifteen under coverage, Goldman observes eleven A-REITs reported stronger-than-forecast results, while seven upgraded or tightened full year guidance. The broker finds relative value still exists in Mirvac, Goodman Group ((GMG)), Dexus Property ((DXS)), GPT ((GPT)) and Hotel Property ((HPI)).

Most A-REITs are trading well above Deutsche Bank’s fundamental valuations. The broker envisages scope for only 25 basis points of sustainable tightening in cap rates and, after adjusting for the prevailing level of lease incentives for each asset class over time, accepts apparent mispricing is reduced meaningfully.

That said, assuming a “lower for longer” interest rate environment, consensus expectations suggest tighter cap rates will flow to higher valuations and, subsequently, higher prices for A-REITs. Deutsche Bank’s analysis suggests differently. The broker uses 100 basis points of sustained cap rate tightening as an example, showing it would reduce effective replacement cost rents by up to 29% and drive net operating income declines for most of the sector. Hence, quality portfolios matter more than ever.

The broker concludes that while cap rate tightening is initially positive for real estate values, ultimately it means tighter exit cap rates and, with lower funding costs, this would enable developers to make projects seem viable with lower rents. In a period of subdued tenant demand there will always be developers sacrificing a super margin in order to get these developments leased up as quickly as possible. This scenario suggests to Deutsche Bank that market rents will come under downward pressure over time. In turn, so will income.

This is particularly the case in office and CBD projects, but the broker suspects that if the same feasibility analysis were run on other asset classes, the outcome would be similar for neighbourhood retail – especially as supply in this area is driven largely by the major tenants. The broker hastens to point out that this extent of market rent decline is not forecast and another 100 basis points of cap rate compression is also not likely to be on the cards. Simply put, cap rate compression driven entirely by lower return requirements does not necessarily have positive ramifications down the track.

The class that performs the best in this scenario is regional malls. When development does occur in this segment it is nearly always undertaken by the long-term owners, which are not likely to undermine rentals at their existing assets. Hence, Scentre Group, Westfield and Goodman would be relative winners. The losers in this scenario? Those with only “average” quality assets and limited development capacity. On the basis of the feasibility analysis and after a strong price performance, Deutsche Bank downgrades Dexus, Investa Office ((IOF)), Cromwell, Charter Hall ((CHC)) and Novion ((NVN)) to Sell from Hold and Stockland to Hold from Buy.

UBS considers, post reporting season, residential is the pick of segments, with both Mirvac and Stockland refining guidance upwards, supported by lower interest rates. The broker observes office shows no underlying growth while regional retail is picking up. This broker, too, notes subtle changes in strategy, as both Scentre and Westfield move away from a capital light model, choosing to reinvest in their best assets and hold onto them.

Regional mall pay-out ratios look set to decline as UBS notes they are the last remaining asset class where distributions are greater than free cash flow. This will affect Scentre and the, potentially, merged entity of Federation Centres ((FDC)) and Novion. UBS is also somewhat alarmed at the upward trend in corporate costs and will be watching this area closely at the August results.
 

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