Time To Look At Growth, Not Yield, For REITs

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-A-REIT dividend yield robust
-But focus on yield ebbing
-Accretive acquisitions a key
-Growth from better use of liquidity
 

By Eva Brocklehurst

The sell down of the Lowy family's 7.1% of Westfield Retail Trust ((WRT)) and the purchase of a stake in 567 Collins Street, Melbourne, by Investa Office Fund ((IOF)) in recent days have triggered a sector review among brokers.

BA-Merrill Lynch notes the Australian Real Estate Investment Trusts (A-REITs) offer a dividend yield of 5.2% but the intense focus on dividend yield to the exclusion of growth may be ending. Most A-REITs are already paying out close to 100% of free cashflow, limiting yield upside. With the potential for global long-end rates to trough and a peaking in liquidity, the broker thinks a switch away from yield trades is likely. This may coincide with further equity raisings, either by the A-REITs themselves, or via block trades by major investors taking advantage of the current high prices, witness the Lowy decision. Upside can be expected from accretive acquisitions and Investa Office's purchase is a case in point. Nevertheless, the broker finds valuations overall are not that compelling.

Morgan Stanley is cautious too, agreeing that the sector looks fairly valued. As fundamentals slow, the increasingly thin dividend premium compared with the ASX 200 is insufficient, and causes this broker to think about taking profits. Top picks are Goodman Group ((GMG)), Stockland ((SGP)) and Charter Hall Retail ((CQR)). Companies such as GMG, SGP and Westfield Group ((WDC)) have greater ability to expand earnings, according to Morgan Stanley, through developments and funds management. In the case of WDC and GMG they also offer exposure to higher growth markets offshore. After 4-5 years of cleaning up balance sheets, the sector is at last looking for growth. For this broker, performance will be determined by stock specific factors more than trends in the marketplace.

Merrills flags a few stocks trading at discounts to valuation and to net asset backing. These include Astro Japan Property ((AJA)), Challenger Diversified ((CDI)), IOF and WRT. The potential for investors to continue searching for yield and earnings certainty, and the probability of retail investors returning, means the broker's chief Buy call is on WRT and explains the Hold status on WDC.

In Morgan Stanley's opinion, despite growth in rental rates slowing, A-REIT earnings will remain defensive. The sector could outperform if there are significant downgrades for the wider market and industrials or further declines in interest rates. Until then, reserve a place in the holding bay. Merrills also notes the case for further price upside is quite dependent on yield compression or price/earnings expansion, underpinned by security of cash flow and strong balance sheets. Alternatively, upside surprise could come from an acquisition and/or development strategy, arbitraging the lower cost of capital. Stand by for any announcements.

A-REIT distribution yields are now far less important, Morgan Stanley contends, while payout ratios are expected to diverge further. A number of the simpler trusts have gradually increased payout ratios, in order to remain relevant to a market that was clamouring for yield. For the broker, this is well and good in a period where growth opportunities in terms of developments and acquisitions are less compelling. With the rapid decline in the cost of debt in the past 6-18 months, some of these growth opportunities start to play a bigger part. So payout ratios close to 100% or above that are unsustainable, in Morgan Stanley's view. The reason is others that are paying out a lower rate may be in a stronger position to fund growth. The broker notes, in SGP's case, the company is hoping to grow into its payout ratio, with stronger forecast growth compared with peers.

Merrills notes investor appetite for real estate as a store of wealth suggests property values should increase in Australia. As most A-REITS now have some leverage to third party flows and are no longer just passive investors, this provides further leverage. Hence, despite valuations not being compelling, the broker believes the sector will continue to rise. Average gearing in the sector is still low and Merrills cites WDC having $6 billion in spare liquidity. The spread of dividend yield to long-term bonds and implied capital rates to bond is undemanding from a historical perspective and supports the view that, if investors value income return as a high proportion of total returns, then higher valuations are justified, referencing Discounted Cash Flow or Net Asset Value metrics.
 

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