Brokers Still See Value In REITs

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 – A-REITs outperformed in October
 – Further outperformance seen as possible
 – Brokers review sector views
 – Deutsche adjusts ratings and targets across the sector

By Chris Shaw

For October Australian real estate investment trusts (REITs) delivered net gains of 5.3%, which compare to a 3.0% gain for the broader market. Year to date the Australian REIT sector has outperformed the broader market by around 16% in total.

Supporting this outperformance in the view of BA-ML has been the sector's stable earnings profile and the yield compression trade. Looking forward, BA-ML expects an increase in equity raisings in the sector, this given many REITs now trade at or near net tangible asset levels and asset yields are in excess of debt costs.

In BA-ML's view this should contribute to the ability of REITs to grow earnings per share, which should boost valuations. As well, the potential for further cap rate compression across the market suggests to Deutsche Bank that further outperformance for the sector is possible.

The gains so far in 2012 have the sector looking fairly priced in the absence of further cap rate compression, but Deutsche suggests a further 50 basis points of cap rate tightening is likely given bond yields have tightened and inflationary expectations have risen in recent months. This has increased the spread between cap rates and bond yields.

Assuming such a compression in cap rates occurs, Deutsche estimates the sector would be trading on an average of 0.93 times adjusted net asset value.

Given a tightening in cap rates would likely deliver associated net tangible asset increases, Deutsche has lifted price targets across the sector by an average of 9%. This has prompted a number of ratings changes, with Deutsche both upgrading and downgrading recommendations across the sector.

Among the upgrades are CFS Retail Property ((CFX)), Dexus ((DXS)), Stockland ((SGP)) and Westfield Retail Trust ((WRT)) to Buy from Hold and Commonwealth Property Office ((CPA)), Investa Office ((IOF)) and GPT ((GPT)) to Hold from Sell. The changes also reflect recent underperformance from CFS Retail, Dexus, Commonwealth Property Office, Investa Office and Stockland.

At the same time Deutsche has downgraded Goodman Group ((GMG)) to Hold from Buy and both Charter Hall Retail ((CQR)) and Cromwell ((CMW)) to Sell from Hold to reflect recent outperformance.

Goldman Sachs has also reviewed the market and sees further potential for REIT outperformance as investors continue to seek yield and anticipate net tangible asset growth and transaction-driven earnings per share gains.

For Goldman Sachs, this ability of some REITs to generate events that drive earnings growth over and above organic growth should see continued investor demand, even given recent strong performance across the sector.

Looking at the residential sector, on face value Goldman Sachs sees some value given trough earnings and signs of a recovery in residential development approvals that is not yet being priced into the market. There are some issues though, the broker noting that as capitalised interest as a percentage of inventory has risen materially, inventory quality is falling, which implies margins on total inventory will follow.

One opportunity for many REITs in the view of Goldman Sachs is cost of debt, as companies such as GPT and Dexus have restructured out of the money hedges to boost earnings per share growth. Companies offering significant earnings upside from normalising their average cost of debt according to Goldman Sachs include Australand ((ALZ)), BWP Trust ((BWP)) and Mirvac ((MGR)).

As with Deutsche, further cap rate compression in the REIT is expected by Goldman Sachs. Yield spreads are most apparent in the office sector, following by industrial and then retail.

Following its monthly review, Goldman Sachs has a Buy rating on Westfield Retail and Sell ratings on BWP Trust and Westfield Group ((WDC)). All other stocks covered by Goldman Sachs are rated as Neutral. 

For Macquarie, some interesting themes emerged from September quarter updates by Australian REITs. One was lower inflation is increasing the challenges faced by Westfield Group and Westfield Retail, as retail sales growth is not keeping pace with rent growth. This means occupancy costs continue to increase.

For residential developers product mix remains the key in Macquarie's view, as September quarter updates showed trading conditions continue to deteriorate in Victoria but are improving in New South Wales.

In the office market Macquarie suggests conditions remain challenging and appear to be weakening given mixed occupancy outcomes across portfolios and tough economic conditions. The latter is contributing to weaker demand and increases in sub-leasing space.

Quarterly updates from stocks under coverage by Macquarie in general reaffirmed earnings and distribution guidance, with only Stockland delivering a negative surprise. This underpins Macquarie's view the REIT continues to offer a high level of near-term certainty with respect to earnings.

Among stocks under coverage, Macquarie rates Australand, Charter Hall Retail, Goodman Group, Investa Office, Lend Lease ((LLC)) and Mirvac as Outperform, while Neutral ratings are ascribed to CFS Retail Property, Centro Retail ((CRF)), Dexus, FKP Properties ((FKP)), GPT and Westfield Retail.

Following a recent REIT conference, BA-ML notes the sector continues to enjoy improvement in terms of allocation of funds and interest from fund managers. Key reasons for this according to attendees include secure earnings, high relative yields and local interest rate benchmarks.

BA-ML notes most participants at the conference expect an improvement in commercial property values, this based on views of the outlook for the interest rate cycle and expectations for further population growth to support underlying demand.

Another point made by attendees was that balance sheets in the sector remain conservative, as foreign investors in particular would be happy to see higher gearing levels given the expectations of rising asset prices and lower debt costs.

As well as the real estate conference, BA-ML has undertaken an asset tour covering properties across all asset classes and located in Sydney, Melbourne, Brisbane and Perth. For retail developments visited, BA-ML notes there is a general sense of resilience in the premium malls, as occupancy remains strong, new tenants are available to fill vacancies and development works continue to progress.

Conditions in office markets are more mixed, as tenants are more cautious now than earlier in the year in terms of committing to new space. BA-ML expects the Brisbane market is more bearish given public sector job cuts, while Perth appears the strongest of the markets as new supply remains limited.

In residential markets BA-ML sees conditions as stabilising, with Western Australia and New South Wales offering the strongest signs of improvement and Victorian land volumes appearing to have bottomed.

 
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