Can A-REITs Continue To Outperform?

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-AREITs not so low risk now
-New leasing deals/incentives
-Melbourne/Sydney office vacancies rise
–AREITs could still outperform
 

By Eva Brocklehurst

Owning Australian retail real estate investment trusts (REIT) has been a no-brainer in the past 25 years, with 12.5% total returns per annum and volatility less than half that of office AREITs. Sorry, but that's past tense. The AREITs as a sector (retail, office, industrial) finished the financial year up 24.2%, outperforming the S&P/ASX 200. FY13 is the fourth straight positive year. AREITs are averaging 15.4% per annum return versus 10.2% for the S&P/ASX 200.

What's in store for the future? Portfolio quality remains high but changes in tenants and leases are affecting the risk dynamics in Morgan Stanley's view. Investors need to be aware that retail AREITs are no longer such a low-risk, high-return asset class.

Landlords have been a lot more realistic about the challenges facing rental growth in the past 6-12 months and incentives are an increasingly important dynamic within retail, making comparability of portfolio performance much more difficult. From an investor perspective, the lack of consistency in disclosure around both re-leasing and importantly incentives will be an issue in determining value.

Morgan Stanley notes more attractive deals are generally being done by the larger retail chains with stronger negotiating power. Smaller retailers are still largely influenced by what the landlord wants when leases are up for renewal but, even so, the ability of landlords to subsidise better deals for larger chains is being hampered by the fact smaller chains and independents are struggling to pay higher rents. Morgan Stanley's feedback suggests categories such as food, fashion and health are sustaining a shift to longer lease terms, greater than the five years which was the historical norm. In contrast, there's an increased prevalence in neighbourhood centres of shorter term leases. The analysts would not be surprised if more short term leasing is also occurring within larger centres to mask pressure on occupancy.

Morgan Stanley observes some less familiar structures are turning up. These include deals that essentially limit a retailer's occupancy costs to 15% (gross rent to gross sales), leases with 2-year sunset clauses where the retailer has a right to exit within three months of 2-year anniversary if turnover does not meet a certain figure, and leases that either keep rents flat for the first two years or remove escalations after four years. There are also break clauses in leases occurring where the tenant can simply elect to break the lease but pay a penalty plus possibly some claw-back of fit-out contribution. Some of these new lease types may explain some of the disparity the analysts are finding in re-leasing momentum across landlords. Although transparency is difficult to obtain it appears leasing strategies across landlords differ meaningfully.

If leasing structures become increasingly tied to retailer performance, Morgan Stanley asks whether we should change the way underlying assets are valued. New leasing structures are probably still in the minority of deals done but. combined with changing lease terms and/or duration and increased use of incentives, the valuation approach to the asset class may need to change. Either way, the analysts argue that valuers should possibly adjust discount rates higher. Ultimately cash flow is the key.

Retail analysts at Morgan Stanley believe there is an improving trend but consumer sentiment remains fragile, reflective of a generally subdued macro-economic environment. Lower interest rates and slowly improving momentum in house prices is a tailwind for household wealth and disposable incomes and cyclical factors should outweigh the structural headwinds facing retail. Morgan Stanley thinks this will favour larger operators. Non-discretionary categories are the best performers while furniture, books and newspapers remain weak.

What about office AREITs? Sydney and Melbourne vacancy rates continue to be driven by the prime grades to which the AREITs are most exposed, and sub-lease space now represents around 19% of total vacancy across the two markets. Headline vacancies deteriorated significantly in the June quarter. Sydney rose by 77 basis points to 10.24% across all grades and Melbourne by 147bps to 10.02%. Demand is likely to continue to be tempered by prime grade vacancies in Sydney and Melbourne. This detail is even worse than the headline. Prime grade vacancies increased over the June quarter by 133 basis points and 235 basis points to 11.3% and 8.7% respectively. Secondary grade vacancy was broadly flat.

Deutsche Bank has adjusted 4-year average office rent growth forecasts down by 50 basis points per annum. Sydney is seen down 2.3% per annum and Melbourne down 3.3%. A steeper decline over the next 18 months is expected, followed by a sharper rebound. Office AREIT earnings estimates are down on average by around 0.7% per annum over FY14-16. Investa Office ((IOF)) remains the broker's preference, reflecting a balanced lease expiry profile and attractive relative value metrics. Commonwealth Property ((CPA)) appears fairly priced and Dexus Property ((DXS)) fully priced.

Deutsche Bank suspects the combination of Australian dollar volatility, rising bond yields, and the deterioration of occupier market fundamentals will temper investor demand and the associated upward pressure on direct market values. Valuation cashflow projections are increasingly reflecting declining market rental growth, rising incentives and protracted vacancies. AREITs to date have reflected stable cap rates, which in an environment of declining market rents should generally translate into lower internal rates of return.

Over in Perth there are challenges in store for both retail and office AREITs. Morgan Stanley has found that major CBD projects are set to deliver the equivalent of two "Barangaroos" in the next 5-10 years. This equates to a 55% increase in prime stock in a city one third the size of Sydney. Demand fundamentals are weakening as mining capex eases and the analysts suspect (or even hope) that a lot of this projected supply will be deferred. Sales of affordable housing, land and apartments may still be strong but a slowdown in business investment will eventually hit there. Retail centres may be seeing good turnover in Perth but there appears to be risks on the horizon for the retail AREITs.

All AREITs that reported June distributions prior to year end, produced flat or positive distribution growth in FY13, with the sector overall signalling 2.3% distribution growth on a market cap weighted basis. Although there were significant variations between stocks, the sector had an average payout ratio of 82% of earnings in FY13. June half dividends were on average in line with BA-Merill Lynch's estimates, with Dexus (5.1%), Charter Hall ((CHC)) (3.4%) and Challenger Diversified ((CDI)) (2.7%) the biggest beats versus the broker's estimates.

At first glance, the AREITs offer substantially less earnings growth next year with the market consensus for just 4.7% in FY14 versus the ASX200 at 10.8%. Merrills observes that AREITs have ended up delivering higher earnings growth in both of the last two years, despite having lower growth expectations at the beginning. Hence, Merrills retains a view that this trend can be repeated in FY14, given the weaker economic outlook. The AREITs' lower risk earnings streams, 90% of which comes from passive property rents and mostly fixed increases, should drive the outperformance.
 

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