Buybacks Enhance REIT Potential

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 – Australian REITs outperformed in April
 – Sector approaching fair value but lower interest rates supportive
 – Capital management a focus in the sector
 – Brokers update some sector preferences

By Chris Shaw

Australian REITs (real estate investment trusts) performed well in April, gaining 5.5% and outperforming the 1.4% total return increase in the broader market. The outperformance reversed the 191 basis point underperformance the sector recorded in March and takes sector outperformance to 11.4% over the past 12 months.

The solid results achieved in April mean A-REITs have continued to close the gap to net tangible asset value (NTA), JP Morgan estimating the gap as at the end of April was a discount of about 1.3%. Despite this, the broker notes there continue to be some valuation anomalies, as Westfield Retail ((WRT)), Stockland ((SGP)), Mirvac ((MGR)), Centro Retail ((CRF)) and Australand Property ((ALZ)) are trading at average discounts to NTA of 19%.

Despite the outperformance the A-REITs remain attractive in the view of BA Merrill Lynch, as the sector offers an average dividend yield of 6.0%, which is attractive relative to the current 10-year bond yield. 

Macquarie estimates the sector yield spread relative to bond yields is now 287 basis points, which compares favourably to an average spread over the past 10 years of 176 basis points. In Macquarie's view while the A-REIT sector is now approaching fair value the combination of a high level of earnings certainty, attractive yields relative to bonds and solid capital positions is likely to translate to maintained or increased exposure to the sector among investors that expect long-term interest rates will stay low for some time.

BA-ML shares this view, noting while recent share price gains across the sector have reduced the sector's attractiveness, with interest rates trending down stocks in the sector are likely to see further support notwithstanding current fundamentals.

Macquarie has extended its analysis to factor in the impact of lower risk free rates, noting its models for the sector currently assume a risk-free rate of 5.5% against a current 10-year bond rate of about 3.4%.

As examples, Macquarie estimates if the risk-free rate was reduced to 4.5% its valuation of Westfield Group would increase to $11.01 from $9.02, all else being held constant. For Westfield Retail the increase in valuation would be to $4.05 from $3.35.

During April the A-REITs continued to focus on capital management, BA-ML noting Westfield Group ((WDC)), Dexus ((DXS)) and Centro Retail all announcing asset sales programs, while Dexus has also started an on-market buyback. This brings to eight the number of A-REITs either undertaking or having recently completed buybacks.

Despite the buyback activity BA-ML estimates the sector ex Westfield Group and Goodman Group ((GMG)) continues to trade at a discount to net tangible assets. This suggests to the broker capital management will remain a focus for the sector.

UBS agrees, noting since August of last year A-REITs have bought back $1.13 billion in stock, which equates to around 1.7% of total market capitalisation. Given a total value of such buybacks of around $4.36 billion has been announced, this process appears to be only around one-quarter complete.

The buybacks are making sense, as JP Morgan notes operational buybacks have seen $1.1 billion of stock repurchased at an average discount to last reported NTA of 14%. This is equivalent to paying $1.0 billion for $1.2 billion of book value, the discount implying NTA accretion of 0.7%. 

The average price paid on UBS's numbers has been a discount to NTA of about 12% and the broker notes all stocks with active of recently completed buybacks have exhibited positive total returns from the time of announcement of the program to now. Most of the buyback stocks have outperformed relative to the sector.

At the same time BA-ML notes asset acquisitions are now accretive for a number of A-REITs as the cost of capital has fallen in recent months. On BA-ML's numbers, asset acquisitions at cap rates in line with weighted averages and funded 70% equity and 30% debt wold be earnings accretive for BWP Trust ((BWP)), Investa Office ((IOF)), Westfield Group, Commonwealth Property Office ((CPA)) and Goodman Group ((GMG)). 

With respect to quarterly updates across the sector, BA-ML notes March quarter management commentary from a number of A-REITs indicated market conditions remain challenging. This is the case across most markets, as developers indicated buyer confidence remains subdued while for office managers Melbourne appears the most difficult market given significant supply coming online.

A number of the quarterly updates indicated earnings remain on track relative to previous guidance, even though as JP Morgan notes commentary indicated the March quarter was tough for new retail leases in particular. Office portfolio occupancy has continued to creep higher.

Given the pressures on new retail leases, JP Morgan continues to see better relative value in Westfield Retail, Stockland, Mirvac and Investa, all of which are rated as Overweight, than in the Hold rated GPT ((GPT)) and CFS Retail Property ((CFX)) and Charter Hall Retail ((CQR)), which is rated as Underweight.

As part of a recent tour of residential and commercial assets in Perth, JP Morgan notes population and wage growth in Western Australia are running at nearly double the national averages, while unemployment in the state is below that of east coast states.

In JP Morgan's view the Perth residential market is stabilising after peaking in 2007, as recent data suggests residential rents are again growing solidly as vacancies have fallen below 2.0% and there has been a reduction in the overhang of established product.

The office market is also showing strong rental growth as vacancies here are also low at 2.0% as at March 31. This low level of vacancies may trigger another redevelopment cycle, but with high construction costs at present new developments are likely to require a sizable pre-commitment in JP Morgan's view.

In the retail market redevelopments are being pushed out due to planning difficulties, while changes in trading hours restrictions are coming and are likely to offer some benefits according to JP Morgan.

This positive state of the WA economy supports JP Morgan's preference for exposure to company's with operations in the state, though the broker notes such exposure via A-REITs is more difficult to access. Those companies weighted to the WA economy are Aspen Group ((APZ)), Peet & Company ((PPC)), Centro Retail and BWP Trust. Others offering reasonable exposure include Westfield Retail, Stockland, Australand Property and Mirvac.

Among the A-REITs under its coverage, BA-ML has Buy ratings on Dexus, Mirvac, Westfield Group, Astro Japan Property Trust ((AJA)), Challenger Diversified Property ((CDI)), Centro Retail, Charter Hall Group ((CHC)), Cromwell Property Group ((CMW)), FKP Property Group ((FKP)) and Investa.

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