Is The Outlook For AREITs Diverging?

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-Residential conditions improving
-Retail leasing remains tough
-Cap rate compression expectations ease
-Interest rates remain a tailwind
 

By Eva Brocklehurst

The latest reporting season has highlighted some disparities developing for Australian real estate investment trusts (AREIT). Residential conditions are improving but retailing remains weak, or deteriorating. Results were mostly in line with expectations but cost savings have been exhausted and commentary is now swinging towards earnings and top-line growth. Themes such as cap rates – the ratio comparing book value with income – and capital partnering, that dominated a year ago, are less evident. Share buy-backs have re-emerged.

The sector underperformed the S&P/ASX200 over reporting season, driven by a combination of the variable tenancy in the office and retail segments and the recent increases in the long bond rate. JP Morgan notes CFS Retail ((CFX)) and Commonwealth Property ((CPA)) were the top performers, following Commonwealth Bank's ((CBA) internalisation proposal.

The residential outlook has improved. Sales volumes in terms of settlements and pre-sales both exceeded Deutsche Bank's expectations. Residential AREITs, Stockland ((SGP)) and Mirvac ((MGR)) outperformed over August, up 6.5% and 1.6% respectively, reflected the improving conditions. It does suggest that returns on investment will head higher in 2014 and 2015, with the pre-sales a good indicator. Development margins across the board have improved since December but Stockland's FY16 operating profit margin guidance of 11-13% did point to a slower run-down of impaired lot sales than the broker had had been looking for, while Mirvac's expectations for development earnings to normalise beyond FY14 suggested meaningful growth into FY15 and FY16 may be problematic.

Retail leasing is the tough one. Spreads have deteriorated, with a bigger impact on the shopping malls compared with the sub-regional and neighbourhood assets. Incentive levels are hard to gauge across the retail sector, but JP Morgan's findings suggest landlords are flexing the rents just as much as is necessary to keep centres full. The broker also notes the material disparity between recovering residential conditions and deteriorating retail conditions, which could be construed as a positive leading indicator for retail landlords, although no major recovery is expected any time soon. Deutsche Bank saw some improvement in the retail sector but this was predominantly driven by supermarkets. Management commentary was generally subdued. Many indicated the drivers of retail spending were, on balance, positive as low interest rates continue to flow though the economy. Nonetheless, consumers remain cautious.

Deutsche Bank thinks the potential for further FY14 downward revisions to growth forecasts in the industrials sector will enhance the appeal of AREITs. In the office segment, vacancies and incentives continue to rise. Market commentary was generally consistent amongst office landlords. Office fundamentals remain challenging, leasing incentives remain high on the back of subdued demand and there is limited new supply in most markets. While highlighting challenges in the retail and office markets, management teams guided for earnings growth of 4.5% on average for FY14, according to BA-Merrill Lynch, benefiting from embedded rent growth, falling interest rates, recent acquisitions and other capital management initiatives, normalising residential development returns and strong funds-under-management growth for the property managers.

Another theme was the moderation in cap rate compression expectations, as there were no meaningful cap rate tightening in the results. Deutsche Bank sees cope for around 30 basis points of cap rate tightening over the next 12-18 months. Cap rates compressed modestly in FY13 and, combined with soft rental growth, valuations were typically flat to slightly positive. Increasing long bond rates and a falling Australian dollar have reduced expectations for further compression, although JP Morgan thinks there could be another 25 basis points for the best assets with the longest weighted average leasing expiries (WALEs). The broker thinks it will be interesting to monitor hedging behaviour from here as the yield curve normalises towards the typical upward slope. New hedging of debt will have an adverse effect on near-term earnings relative to leaving the rate floating.

UBS noes interest rates continue to remain a tailwind for AREITs in light of deteriorating top line revenue growth. Given the Australian dollar floating rate is at the lowest levels in history and, relative to where REIT average debt costs are currently, this is likely to remain a tailwind in FY14. Retail AREITs on average have lower hedging in outer years. The broker thinks an argument could be made that the cyclicality of retail is a natural hedge to rising bond yields but still has concerns with some of the structural factors. This has resulted in subdued retail sales growth and limited inflation, particularly in apparel. As a result, this exposes retail AREITs to lower outer-year earnings growth.

AREITs have struggled to shed the bond market derivative trade, in UBS' view. If marking to market a risk-free rate assumption, the move from 3.20% to 4.0% would imply a 12.0% decrease in the sector's fair value. In comparison, the AREIT market has sold off 8.0% and underperformed the broader market by 10%. In summary, the market appears to be pricing in a 5% 10-year bond rate versus UBS' valuations of 4.5%. Charter Hall ((CHC)) looks most favourably exposed to low floating interest rates, in the broker's opinion, followed by Dexus ((DXS)), Bunnings Warehouse ((BWP)), Westfield Retail ((WRT)) and Investa Office ((IOF)). Goodman Group ((GMG)) has a $1bn cash position in Australia and therefore should be negatively impacted by a decline in the floating rate. At the long end of the yield curve, GPT ((GPT)) has termed its interest rate derivatives with 80% of its debt book fixed at 5% out to FY17.

There are moves among the AREITs to adopt a new funds from operations (FFO) definition. A number of AREITs will move to FFO reporting in line with best practice reporting guidelines. In this case Dexus' material level of rent-free incentives running through its office portfolio will see its earnings up by 6.2% (DXS estimates), while Stockland and Mirvac would also benefit by 6.9% and 2.2% respectively, on Deutsche Bank's estimates. On the flip side, guidelines for expensing of share-based remuneration would negatively impact Goodman and Charter Hall.

So, which stocks are on the tick list? The season reinforced Merrills' Buy ratings on Lend Lease ((LLC)) and Mirvac as the leading developers, with diversification that reduces single project risk, while pre-sales of both apartments and commercial property projects provide comfort around funding capacity and earnings visibility. Westfield Retail's 30bps higher distribution yield underpinned the broker's decision to switch from CFS Retail into Westfield Retail. With Commonwealth Property also being driven by internalisation and other non-core factors, Merrills sees good value and potential catalysts in Investa Office and Dexus. As a pure play fund manager the broker prefers Charter Hall from a value and momentum perspective. Australand ((ALZ)), Bunnings and FKP Property ((FKP)) are rated Underperform.

The season did not throw up any great surprises on the earnings front for JP Morgan, with the exception of Australand, which missed by 5%. Operationally, Investa had strong leasing outcomes while solid residential pre-sales are being carried into FY14 by Mirvac and Stockland. Non-discretionary retail rent spreads are solid for Stockland and Charter Hall Retail ((CQR)). At the other end, two negative surprises were the intensity of negative leasing spreads for Westfield Retail and Australand. Preferred exposures are Mirvac, Stockland, Dexus, Westfield Group ((WDC)) and Charter Hall.
 

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