Rental Growth Subdued For Retail And Office A-REITs

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-International retailers provide price tension
-How feasible is residential above malls?
-Office vacancies highest in Brisbane
-Best rental growth in Sydney and Melbourne
 

By Eva Brocklehurst

Macquarie has explored some themes in the retail side of Australian Real Estate Investment Trusts (A-REIT). This includes the prospect of further tenant mergers as an avenue for securing shopping centre space, and the ability of the apparel and footwear tenancies to sustain higher rents. Also, what's the potential for adding residential apartments above shopping centres as a means to improve the feasibility of retail redevelopment?

The broker believes international retailers will continue to seek space in Australia via new stores but they could also be facilitated by the merging of existing tenants. This should benefit landlords, offering the potential to obtain a better capitalised tenant. In terms of those best placed in this event, Macquarie considers the regional malls of GPT Group ((GPT)), Westfield Retail ((WRT)) and CFS Retail ((CFX)) will likely benefit. The broker lists a large number of international retailers seeking Australian space – almost 300,000 square metres in aggregate. A portion of this demand will be supplied from the roll out of new stores in shopping centres under redevelopment but it also augurs well for demand as existing space is rationalised.

Macquarie thinks corporate takeovers will facilitate the expansion of international retailers in Australia. The broker looked at takeover activity among major retailers offshore and was interested to see that Canada's Hudson's Bay Co acquired Saks department stores in the US to improve breadth and scale by moving into luxury retailing. The rationale also involved taking Saks to Canada. Why is this interesting? It's an example of a local operator seeing the positives in a foreign brand and acquiring that brand in order to roll it out in the local market. A situation such as this for domestic landlords in Australia would be positive, in Macquarie's view, and provide pricing tension for retail space in Australia to the benefit of the aforesaid mall operators.

The potential to obtain higher rents from the handing back of leasing space is very positive at a headline level, but Macquarie warns that the capital expenditure may be elevated to the extent that the outcome actually ends up being, at best, neutral. The broker observes from its surveys that sales growth and profitability has improved from the tenancies of apparel and footwear retailers but this is partly attributable to lower rent. Three apparel chains remain loss making. The impact of a lower Australian dollar has also not yet been felt and this should provide upside risk to costs as the retailers acquire stock for the next season.

Overall, the broker forecasts negative rent reversions in retail. The broker has been of the view for some time that rental growth in excess of sales growth cannot occur into perpetuity and a re-basing of rents, particularly for underperforming tenants, needs to occur. Despite the moderation in occupancy cost ratios, which will return these retailers to a sustainable base, rents are still increasing – largely from fixed escalators that are embedded in leases as well as from additional stores. The possibility that more retailers go into administration is a risk for the sector but higher quality portfolios will be best placed to release space.

On the subject of residential apartments being built above shopping centres, this may make the redevelopment more feasible, but the broker is not getting carried away. The opportunity is very specific to the centre and there are restrictions and complications for such developments, including a strata title that can require apartment owner approval for future shopping centre development, as well as potential disruption at the shopping centres while construction is occurring. The returns are highly sensitive to project size, final sale price and developer margin. The stocks with mixed use capability that would be best placed to take advantage of this situation are Lend Lease ((LLC)) and Mirvac ((MGR)), as they have in-house development capability as well as passive shopping centre investments.

In the office segment, Citi observes high leasing incentives, negative growth in effective rents and high levels of vacancies. Nonetheless, asset values are improving and supply seems contained. Foreign and domestic capital are competing aggressively for assets and the broker wonders whether investors expect an improvement in rents. Will this happen? Citi thinks any rental improvement will be demand driven. There is also a lag between changes in occupancy and movements in rent. On balance, the broker finds some indications of demand improvement. Moreover, given the long lead times for office development, it is easier to be accurate with the forecast for new supply in this area in the near term.

Citi calculates the volume of occupied space provides the best relationship to rental growth, thereby believing 2014 should show positive rental growth. Rental growth is expected to take the form of a reduction in incentives in 2015. The broker prefers Investa Office ((IOF)), given its existing debt capacity and low cost of debt, which allows for accretively debt funding acquisitions.

Credit Suisse believes the impact of space rationalisation has washed through Australia's office market with vacancies standing at 11.7% in the March quarter. There was a sharp reduction in sub-lease space, particularly in Sydney, and net withdrawals of space nationally. Incentives increased and were highest in Sydney and Melbourne, followed by Brisbane. Demand recovery is expected to be led by Sydney and Melbourne in the second half, but the supply offset is expected to mean incentives remain elevated and effective rental growth stays muted.

Vacancy rates in Melbourne are now, at 10.4%, the lowest of all the major CBDs. Meanwhile, Sydney's premium and A-grade vacancies are above long-term averages. Credit Suisse notes net absorption in Perth has declined for seven consecutive quarters and vacancies have lifted to 11.8%, while incentives surged to 22% from 7%. Brisbane has the highest vacancy rate at 15.5% and Credit Suisse thinks this will stay elevated on a 3-year view, given the pending supply. Overall, transactions are elevated and yields generally stable, in the broker's view. Credit Suisse forecasts 2-3% net effective rental growth nationally per annum over the next three years, driven by stable or lower incentives in Sydney and Melbourne. Negative rental growth is forecast for Brisbane and Perth, given continued resources and public sector downsizing combined with higher supply. In terms of the stocks exposed to office, the broker prefers Mirvac and GDI Property ((GDI)).
 

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