A-REITs To Weather Reporting Season Well

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-Attraction in passive rental income across sector
-Housing recovery, low interest rates supportive
-Industrial supported by logistics, infrastructure
-Perth vacancies surge, demand and rent slides
 

By Eva Brocklehurst

Australian Real Estate Investment Trusts (REITs) seem fully priced but there is comfort to be bought from earnings security. The sector, up 17% year to date and outperforming the market by 11%, should deliver on broker expectations at the upcoming earnings reports. BA-Merrill Lynch is upbeat, noting seven of the 19 stocks under coverage beat forecasts in February's reports, with only three missing by more than 1%. The broker believes the sector may continue to outperform the broader market, given the prospect of further downgrades through the earnings season, and the REIT track record.

The sector is attractive to the broker because it offers a 5.2% dividend yield and FY15 earnings and distribution forecast growth of 4.0% and 3.0% respectively. In Merrills' view, the earnings security comes from having over 90% of revenue derived from passive rental income. The broker cites several themes for the August reports. Retail landlords are still likely to be showing signs of pressure, with negative spreads on new leases and incentives remaining elevated. Property developments should receive greater emphasis regarding their future contribution to growth and there are several development projects that will be completed in FY14. The market will be looking for guidance on project starts for FY15.

Residential market volumes are robust, despite reports of a slowing in the housing sector, and market volumes are around 18% above mid-cycle levels. The broker thinks should allow developers to clear impaired stock and achieve near-term targets. Merrills is overweight residential developers going into the results. Several REITs have reported growth in asset values. Continued compression of the cap rate – the ratio of asset value to producing income – is likely to boost forward asset valuations. Another drop in interest rates over the last six months, with A and BBB rated corporate bond yields falling 50% and 70% respectively,  means a continuing tailwind for REITs, which are typically 60-80% hedged.

Merrills expects the sector to deliver earnings growth of 5.5% for FY14, and 12% if it includes Lend Lease ((LLC)) and Peet ((PPC)). The former is benefitting from the sale of the stake in the Bluewater asset while the latter is beneftting from a recovery in the housing market and a ramp-up of development capital expenditure. Specifically, Cromwell Property ((CMW)) is forecast to deliver 11.7% earnings growth following recent accretive acquisitions, while Mirvac's ((MGR)) 9.6% growth forecasts reflect a turnaround in development returns. Merrills expects CFS Retail ((CFX)) earnings will fall 1.2% as the result of the dilution from the capital raising to fund the internalisation of management. In FY15 Merrills expects 2.7% growth. Key stocks expected to deliver robust earnings growth in FY15 are Charter Hall Goup ((CHC)), 8.3%, Goodman Group ((GMG)), 6.5%, and Federation Centres ((FDC)), 5.0%.

Morgans also expects the sector to do well in the upcoming reports. Further improvements in residential markets and low interest rates provide a backing for the broker's confidence, with positive impacts from funds flow for the fund managers. The broker prefers good quality industrial property, with ongoing tenant demand driven by internet retailers and businesses looking to upgrade logistics infrastructure. Office remains challenging but the broker identifies Cromwell Property as one with a strong weighted average lease expiry profile. Among retail exposures Morgans prefers Federation Centres. GPT ((GPT)) and Stockland ((SGP)) are the pick of the diversifieds. Meanwhile, Westfield ((WFD)) after its restructure now offers investors global exposure.

The outlook for the Perth office market has come under JP Morgan's scrutiny. The broker observes moderating levels of tenant demand, resulting from changing fundamentals in global commodity markets and the transition in the domestic mining and resources industry to less labour intensive operations from the construction phase. JP Morgan expects the Perth vacancy rate to peak at 20% in the next two years with a further decline in net effective rents of around 20%. The sector's exposure to Perth is dominated by Dexus (DXS)), Investa Office ((IOF)) and Mirvac. JP Morgan envisages minimal near-term earnings risk based on lease expiry profiles but suggests asset values may be written down to reflect lower sustainable market rents.

Key to Dexus' exposure is 240 St George's Terrace (Woodside Plaza), occupied by Woodside Petroleum ((WPL)), with a book value of $500m. Should Woodside reach a binding agreement over Capital Square and relocate, then JP Morgan estimates Woodside Plaza could fall in value by 15%, resulting in a potential $70m write down.

Perth's vacancy rates are at 13%, up from 6.5% over the last 18 months. JP Morgan estimates incentives have increased to 27% from 10%, while prime net effective rents have declined 25%. New supply under construction comprises 11% of stock, all due for completion by end 2015. The broker notes this would be the highest level of completions since 1991. Looking at the Mirvac and Investa Office portfolios, the broker expects assets that typically fit these profiles to show valuation declines of 5-10%. Should Woodside move, the Dexus portfolio is expected to decline in value by 10-15%.
 

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