Thumbing Through A Subdued Property Sector

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-Some value appeal in the sector
-Office weak, retail mixed
-Residential the highlight
-Funds management focus increases
 

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) have underperformed for six out of the past seven months and for the third consecutive reporting season. JP Morgan makes this observation, while noting that those with active earnings performed better over February. This list includes Charter Hall Goup ((CHC)), Stockland ((SGP)) and Mirvac ((MGR)). Which lagged? Charter Hall Retail ((CQR)), CFS Retail ((CFX)) and GPT Group ((GPT)).

Stepping down from this broad theme, JP Morgan observes stock specific factors drove any outperformance. Shopping Centres Australasia ((SCP)) was the notable mention here, having announced an opportunistic buy-back and upgrade to guidance. Charter Hall Group, which raised equity to keep up with fund flows and increased guidance, was another. The third, Dexus Property ((DXS)), reached the compulsory acquisition threshold for the remainder of Commonwealth Property ((CPA)). To the broker, notable underperformers were Aveo ((AOG)), Hotel Property ((HPI)) and Charter Hall Retail.

The norm is for A-REITs to underperform the ASX200 when bond yields rise but Morgan Stanley thinks, after underperforming in 2013, that this feature is now priced into stocks. Rising asset values, stabilising fundamentals and restructuring should ensure the sector has enough support, even if yields rise this year. The broker thinks 2014 could set a new record in transaction volumes and stabilising fundamentals will reduce the risk premium for A-REITs. The broker notes that Commonwealth Property and Australand ((ALZ)) have shown that speculation, or actual mergers, can drive meaningful outperformance in relevant stocks and this will likely be a feature of 2014 too. The broker's preference is for Goodman Group ((GMG)) Dexus, National Storage ((NSR)), Arena ((ARF)), Federation Centres ((FDC)), Lend Lease ((LLC)) and Stockland.

BA-Merrill Lynch considers A-REITs are now fairly valued in absolute terms and compared with bonds. The broker observes that inflation is likely to dissipate in the second half of 2014. The Reserve Bank moved to a more neutral bias last last year, in part from stronger inflationary pressures. These pressures were elicited by the initial depreciation of the Australian dollar but Merrills' economists see a case for a markedly decelerating inflation profile in the second half. The broker also suspects that A-REITs are being conservative in their forecasts, as targets may have been exceeded in interim reports but there was no significant upgrades to guidance, which provides for more confidence in FY14 expectations.

Conditions were soft in the second half of 2013 but Merrills thinks some life is emerging in the retail sector, albeit not enough to turn bullish yet. Office portfolios continue to deliver reasonable income growth, driven by rental rises related to the CPI, but Merrills notes effective rent growth is flat to negative. Merrills remains bearish on the office sector in the near term. The broker expects unemployment will continue to rise to 6.5% and there is also the prospect of continued new supply in some areas.

Cash flow fell short of Macquarie's expectations in the December half. While the value proposition across the sector is not appealing, the broker finds some appeal in Goodman, Westfield Group ((WDC)), Investa Office ((IOF)) and GPT. In terms of the residential market, Macquarie observes conditions were strong, reflected in sales rates and contracts on hand for developers. Still, earnings leverage is limited in the near term and so the broker's overall valuations are largely unchanged.

Office conditions have clearly been weak, but Macquarie notes landlords were reporting signs of recovery in Sydney and Melbourne. Retail A-REIT metrics are mixed but still deteriorating and Macquarie thinks this will continue, despite a potential improvement in retail sales over this year. Industrial portfolio metrics have softened and increasing competition in the sector is expected to keep a lid on performance over 2014. Commercial asset classes will benefit from elevated investor demand for assets which will put upward pressure on valuations, in Macquarie's view.

To Goldman Sachs the season was a little muddled because of a change in accounting affected comparisons, but earnings misses were not accompanied by downgrades, and that's a positive. Overall, the broker has downgraded earnings forecasts for eight stocks in the sector. Savings on debt costs and corporate overheads drove earnings growth but the broker suspects this momentum has peaked. Office landlords have described conditions as some of the most challenging for many years, confirming the broker's expectations. Shopping centre fundamentals are unchanged. Goldman observes the logistics/industrial segment seems a little more bullish. Residential developers were the highlight, but even so, the broker notes they were not able to upgrade guidance in any meaningful way.

Goldman thinks the Reserve Bank will reintroduce an easing bias in coming months, deducing this from weak indicators such as machinery and equipment investment in the private capex data. A lower growth outlook, with risk for a continuation of low interest rates, has potential to create interest in the A-REITs, which the broker does not think are overvalued. Goldman sees value in Westfield Retail Trust ((WRT)) at current levels, with the balance of risks in the stock's favour. Challenger Diversified ((CDI)) and Shopping Centres Australasia also present value, although Shopping Centres' strong rally over February has meant the conviction is lower as the valuation gap closes.

With scale now apparent in the funds management business of Dexus and GPT, Goldman suspects the contribution to earnings growth will be increasingly difficult to ignore. The broker suggests investors are getting the funds management business for free and rates both a Buy. In the residentially exposed A-REITs the broker's preference is Mirvac, followed by Stockland then Australand.
 

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