Brokers Pick Over Property Sector

This story features MIRVAC GROUP, and other companies. For more info SHARE ANALYSIS: MGR

-Expectations mount for revamped Westfield deal
-Macquarie upgrades Westfield
-Office market turning but still challenging
-Deutsche Bank's picks for 2014
 

By Eva Brocklehurst

What's happening in the Australian listed real estate investment trust (REIT) sector? Talk around the traps centres on the mounting resistance to the deal that Westfield Group ((WDC)) outlined with Westfield Retail ((WRT)) late last year. Brokers note the potential for the terms to be re-worked, although there's no word from Westfield, according to BA-Merrill Lynch, on whether it intends to re-examine the split. The shareholder vote on the proposal is due in May. If Westfield does revisit the proposal to improve the metrics this should be a positive for the WRT share price, Merrills contends.

To recap on the detail – Westfield intends to merge the Australian/NZ business with WRT to create Scentre Group. Westfield will retain exposure to markets outside of Australasia and may have a dual listing in the US. Macquarie believes the Scentre proposal is an attempt to improve Westfield's cost of capital and, while it makes strategic sense for WRT, the price is too high.

For Macquarie, WDC has an improved value proposition. The stock is at a point where growth should accelerate and Macquarie has taken the opportunity to upgrade to Outperform from Underperform. Macquarie believe Westfield's valuation support centres on its exposure to a recovering US market and leverage to a depreciating Australian dollar. The broker acknowledges the poor share price performance may diminish if there's an adjustment to the Scentre proposal. It's just that Westfield's position on the growth curve is a good reason to back the stock.

Mirvac ((MGR)) has suggested 2013 could provide the trough in terms of the office market cycle but the Credit Suisse is not so sure it will turn around at this juncture. Data from the fourth quarter was soft and rents fell in Brisbane and Perth while staying relatively stable in Sydney. Business confidence has improved and growth in CBD office job ads suggests to the broker that demand may be better in six months time. This should be led by Sydney and Melbourne, as the service-based CBD markets recover more quickly than the resource-based markets.

Credit Suisse notes office recovery comes late in the cycle, as opposed to residential and retail assets, but value is emerging. Mergers and acquisitions should support valuations, fuelled by excess debt capacity and a positive funding spread. The broker is concerned about the amount of new supply coming on board in Perth and Brisbane, given the implied level of employment growth required to see vacancy rates return to more normal levels. The national vacancy rate stands at 11.8%, according to Credit Suisse, and is now 350 basis points above the GFC peak of 8.3%. 

Morgan Stanley also expects demand to improve more rapidly in Sydney and Melbourne. The broker observes that, unlike 2007-09 when it was Sydney CBD demand that capitulated, Brisbane and Perth were the main contributors to a fall in office demand in 2013. The broker expects the east coast recovery will be driven by an improving housing cycle and credit growth. The best way to play this, in Morgan Stanley's view, is via Dexus ((DXS)) as that stock's percentage of FY14-16 lease expiries give it the greatest exposure to a potential recovery.

Crunching the numbers, Morgan Stanley finds that a 40% decline in engineering and construction related investment tied to resources in the next three years, amid the current known office supply, could see Perth's vacancies move to 17.5% and Brisbane's to 23%. Several indicators show that demand in Sydney and Melbourne CBDs could even surprise on the upside. The broker is not getting too excited about rental growth. Actual rental growth is likely to lag a return to positive demand by a further 6-9 months in Morgan Stanley's calculations.

Deutsche Bank also thinks it's too early to get excited about office A-REITs and has downgraded Investa Office ((IOF)) to Hold. The broker thinks rental growth is some way off. Top picks on Deutsche Bank's slate for 2014 are Goodman Group ((GMG)), Lend Lease ((LLC)), Stockland ((SGP)), and the two Westfields. With the exception of WRT, these names are considered undervalued. The easy call in Deutsche Bank's view is for a preference for residential exposure to harness the upturn in housing. The broker considers WRT is the primary beneficiary of a recovery in retail conditions and retains a preference for retail over office exposure, after the weak December office data. Deutsche Bank thinks value is best captured by a relatively small number of large cap A-REITs and has recently upgraded Goodman Group and Stockland to Buy. The broker's preferred residential exposures are Stockland and Lend Lease.

Macquarie observes operating conditions across commercial property asset classes remains challenging but a recovery is expected in the medium term, which will drive valuation higher. This should support asset growth while the earnings backdrop is subdued. Macquarie suspects the A-REITs will not keep pace with the broader market but the underperformance that usually accompanies rising bond yields has already occurred. Any further discount to net tangible assets makes the stocks susceptible to takeover and the risk is highest with Investa. As for residential A-REITs, Macquarie does not expect much in the way of earnings upside surprises but believes this area is the brightest spot at the moment as the housing market steadily improves.

Goodman Group's first US development is behind schedule but a depreciating Australian dollar and the residential conversion opportunities offset this. This stock has also been upgraded to Outperform by Macquarie. The broker notes the outlook for equity inflows from wholesale investors is very positive and, for Goodman, every additional $1bn in new equity invested with 40% gearing would increases management earnings by 11% and 2% respectively. The company's global diversity is well matched with wholesale capital and the broker expects these two aspects bode for stable growth in the overall business.

Macquarie has recommenced coverage of GPT ((GPT)) this year with an Outperform recommendation. The company has been unsuccessful with two large merger proposals but Macquarie thinks that obtaining of $1.2bn in assets from Dexus via a memorandum of understanding is a good outcome. Risks for an equity funded acquisition still exist, but the broker thinks the earnings growth pace will improve as the stock is a high quality proposition with retail, office and industrial exposure.
 

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