Australia | May 30 2013
-AREITs to stay high yielders
-Retail rental re-leasing pressure
-Strong distribution growth expected
-Less churn, more rationalising
By Eva Brocklehurst
Amongst the multitude of influences on Australian listed property trusts (AREITs) several things stand out for the broad sector. High on the list is interest rates. Low interest rates exacerbate investor appetite for yield among stocks and AREITs are high yielders, at least since the GFC. It's going to stay that way for a while it seems.
AREITs are also beneficiaries of current low interest rates in terms of their lower cost of capital. As investors price in the lower-for-longer interest rate environment and reduced volatility, this brings down the risk premium required. It's no wonder AREITs are marching along solidly amidst all the uncertainty in other sectors. The sector has returned 72% since August 2011, double that of the broader market. JP Morgan notes a strong inverse correlation between interest rates and AREIT performance re-emerged in 2010 when the sector regained defensive characteristics after the GFC.
There's a twist to low interest rates for the property sector. In boosting demand for property by improving affordability, low rates help AREITs, particularly in the residential segment. The twist comes with what, in part, the low interest rates are addressing – lacklustre consumer and business confidence. If retailers and businesses supplying the consumer are feeling the pinch then this affects AREITs' ability to drive rental/leasing growth and minimise vacancy rates, particularly in shopping centres but also industrial parks and offices. Credit Suisse flags the unusually warm autumn as a case in point. This is having an impact on apparel retailers, which are turning to discounting to offload excess inventory. This puts pressure on re-leasing spreads in discretionary retailer-anchored malls. Specifically, this affects Westfield Retail ((WRT)), CFS Retail ((CFX)) and GPT ((GPT)). The broker is less concerned about the impact on Westfield Group ((WDC)) because of the large exposure to the US.
The connection between low interest rates and retailing confidence is also not as strong as it used to be. JP Morgan believes it signals a moderating of the relationship between net disposable income, consumption, and retailing. More disposable income is being drawn off by cost of living expenses – education, domestic and household services, childcare, medical care and health expenses, and domestic fuel and power.
This difference in the impact of interest rates, and the current environment, on the various AREIT segments underlines the differing cap rate compression (narrowing) expectations – the much talked about scenario for AREITs. The cap rate is a ratio, using both debt and equity, that compares the price, or book value, of an asset with the income it produces. Generally, the lower the cap rate the higher the price of the asset. Here the ratio varies among the segments. For example, regional shopping centre cap rates exhibit the least volatility. JP Morgan expects the reduction in AREITs' cost of capital will take longer to flow through to cap rate compression and is allowing 25-50 basis points in 2013.
Credit Suisse has incorporated around 44-57 basis points of cap rate compression for the office sector. JP Morgan sees less scope for the retail asset cap rate compression, with expectations of around 25 basis points in 2013. This is, in part, because prime retail assets are already trading at tighter spreads to bond yields, and because, unlike office and industrial, they don't have the capacity to be de-risked against the tough leasing environment through long weighted average leasing expiries (WALE). Bond yields are also a clue to the performance of the sector. History suggests a negative correlation between bond rates and AREIT performance. AREITs typically outperform when 10-year bond rates fall and underperform when rates rise. As the 10-year rates have been at low levels for some time, once they start rising the cap rate will also compress to incorporate lower relative returns from property.
The re-rating of stocks based on the dividend yield may be easing off but there are residual tailwinds which should support AREITs trading at or above fair value in the near term. In Macquarie's view earnings growth is accelerating because lower debt costs and corporate cost savings are supplementing the resilient underlying property fundamentals. Strong distribution growth should result. Some current distributions are below estimates of free cash flow but Macquarie thinks retaining capital is sensible for those with organic development pipelines or investment opportunities.
The broker cites Goodman Group ((GMG)), Charter Hall ((CHC)), Mirvac ((MGR)), Stockland ((SGP)) and Australand ((ALZ)) in this bracket. There are also those which are more passive but have the capacity to increase distribution pay-out ratios such as GPT, Investa Office ((IOF)) Dexus Property ((DXS)) and Shopping Centres Australasia ((SCP)). That doesn't mean the broker thinks that paying out unsustainable distributions should be encouraged, it's just that those with low gearing should have the capacity to deliver distribution growth in excess of earning/cash flow growth. Distributions can grow from acquisitions and GPT, Dexus and Investa all have capacity to fully debt fund acquisitions.
Credit Suisse suggests the sector remains cheap, despite looking expensive. The broker prefers Westfield Retail Trust although both Charter Hall Retail ((CQR)) and Federation Centres ((FDC)) have a positive spread between cost of equity and the internal rate of return on their portfolios. Distribution reinvestment plans are also coming back on the agenda as CFX and CQR switch theirs back on. Stockland may start with the June distribution. Moreover, Credit Suisse notes pay-out ratios are lower and deployment of retained earnings should help drive growth. Here, Credit Suisse explains the growth is seen coming from within the sector, given lower volatility earnings profile and dedicated funds.
Segments within the AREITs include office, retail, residential and industrial. Traditionally there has been much overlap but JP Morgan notes AREITs are now streamlining portfolios, which can mean hiving off non-core and offshore assets and recycling capital into prime assets. Those with well directed and concentrated portfolio strategies are the focus for investment. There appears to be some polarisation happening, as entities such as Stockland sees the way forward via a greater focus on residential while Mirvac steps up its office exposure. BA-Merrill Lynch is more concerned about Stockland's direction as the residential business is likely to remain weaker than past years for an extended period. The broker believes Stockland has execution risk in trying to stabilise residential margins. In comparison Mirvac has over 60% of next year's development earnings already secured.
Amid all the positives, business confidence remains anaemic and with this comes the problem of vacancy rates. JP Morgan suspects a recovery in leasing rates is some way off. Effective rents are expected to fall across all markets in 2013, contracting by around 3% in 2013 and growing just 2% over 2014-15. Development is seen as the major driver of office performance. Hence, the broker's preference is for Sydney & Perth over Melbourne, Brisbane & Canberra, and for prime modern stock with large floor plates over secondary stock. In terms of office, all the seven under the broker's coverage with material office exposure are now trading at premiums to net tangible assets (NTA).
The sell down of stakes in quality assets is less compelling these days. Recycling assets – selling them for capital gain – was a capital source when AREITs were trading at material discounts to NTA. Now that the cost of capital and access to capital have vastly improved, acquisitions are more likely to be funded from equity and debt. Cap rate compression also suggests selling down stakes in quality assets is unnecessary. Sydney and Melbourne remain the key markets for office, accounting for 80% of the $20 billion on REIT office assets although allocations to Brisbane and Perth are increasing.
Goldman Sachs noted AREITs registered one of the best months on record in April. Shopping Centres Australasia was the only one to post a negative return, although with the highest yield and longest unexpired lease term, providing earnings certainty, this stock is a buying opportunity, in the broker's view. Best performers in April were Federation Centres, Dexus, GPT and Charter Hall. There's no segment theme here. One is diversified, one is focused on shopping centres, one is focused on office and one on funds management. And they are not the best yielders, with average prospective yields of 5% they are marginally below the sector average. Goldman notes AREITs returned over 8% in April. Nevertheless, the rally in AREITs has led to a view they are expensive, relative to the break up value. It's the thirst for yield that is exacerbating this situation in the near term.
So what's ahead? Stockland and Mirvac have earmarked significant capital for retail development while Federation Centres and Charter Hall Retail are on the acquisition trail. Of interest, JP Morgan has noted that increasing numbers of foreign pension and sovereign funds are making their way down under to source quality real estate assets. The volatile and low-growth global economic environment is pushing these funds into stable high yield markets. The broker cites a study by Jones Lang LaSalle which estimates that 45% of all real estate capital flows into Asia Pacific over 2011-12 were into Australia. This compares to 19% in Japan, 18% in China and 9% in Singapore.
Adding this to domestic super funds that are increasing property allocations, the low gearing environment and inflow into wholesale funds, and what you get is a scarcity of prime assets, along with competitive pricing. This should put downward pressure on core cap rates, in JP Morgan's view. Moreover, cap rate compression of the prime asset markets is likely to filter down to drive compression in the secondary market as well. This will be caused by investors wanting higher returns and becoming less risk averse, along with a greater willingness to make small investments.
Finally, is there a bubble here? BA-Merrill Lynch has explored the question. As modest growth is expected in the mid-term, the quantum of income is likely to be the key. While interest rates stay low and AREITs follow the trend to the long-term yield premium they enjoy versus the rest of the developed markets – around 133 basis points – there is a further 14% rally implied for the AREIT stocks. Moreover, the broker finds the sector price/earnings ratio relative to the S&P/ASX 200 index is 1.07 times, only 4% above the long-term average. The year 2013 may be vastly different to the bull run of 2005/6 in the sense that the rally in AREITs is being driven by low interest rates, rather than a high growth outlook. Hence the sector's defensiveness has been improved via lower gearing, improved debt duration and diversity, along with less offshore/currency exposure. It's a whole lot more stable than it was before the GFC.
Comparing the current 5.1% sector average dividend yield to historical levels does suggest valuations are at an all time high. Based on BA-Merrill Lynch's database of dividend yields, which goes back 40 years, there is no period when yields were as low as they are today. OK, there are some factors that have changed considerably over this period, most notably inflation and interest rates, which have decreased progressively over time. It is also important to note that the pay-out ratio prior to 2008/9 was typically 100% of earnings, whereas now the average pay-out ratio is just 73%, or 98% of free cash flow, a much more sustainable level.
BA-Merrill Lynch notes the AREIT dividend yields have compressed but remain 200 basis points above 10-year bonds and the trend has further to play out. Relatively higher sovereign interest rates should stay lower for longer and asset inflation remains a risk. Supporting AREITs, the great rotation from bonds into equities and from defensive to cyclical seems to be more taking the form of a rotation from fixed interest into bond-like equities, with the resource/cyclical trade still yet to be driven by GDP upgrades. This shows there is a significant gap to "peak-style" metrics.
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