A-REITs: Where Are The Next Opportunities?

This story features STOCKLAND, and other companies. For more info SHARE ANALYSIS: SGP

-Competition for assets intensifies
-Office rents remain weakest
-Residential outlook robust
-Opportunities in fund manager A-REITs
 

By Eva Brocklehurst

Insights into the Australian Real Estate Investment Trusts (A-REITs) gleaned from reporting season include JP Morgan's observation that small cap players with a strong earnings outlook for the next year were the top performers. Overall, the sector's pricing now looks full, outperforming the ASX200 more than 12% over the year to date. Other key themes are that the market for transactions is competitive, while debt costs that are close to market will make outperformance on the earnings growth front challenging.

The lack of equity raisings over the period suggests to JP Morgan competition for core retail estate is intensive. Leasing challenges across the three major asset classes – residential, office and retail – mean income growth is benign. Residential stands out as the best placed, with strong sales increases, margin improvements and high pre-sales from developments. JP Morgan's preference remains with the residential A-REITs over pure office and retail landlords. This boils down to Stockland ((SGP)) and Mirvac ((MGR)).

BA-Merrill Lynch echoes the theme, noting domestic concerns over earnings risk across the broader Australian market have driven investors to increase equity allocations to the sector. This broker's preferences are Stockland and Federation Centres ((FDC)), given there is a more positive organic growth outlook for both stocks, coupled with reasonable valuations. Merrills observes the A-REIT sector is now fully valued, particularly given the relatively soft fundamentals in place across the office and retail segments. Negative re-leasing spreads are commonplace among new leases signed up over the last month. While no longer offering compelling value, Merrills considers the sector's 5% yield remains attractive and should be well supported while interest rates remain low.

Credit Suisse was least impressed with office landlords and expects the weak trend to persist. A gradual improvement is expected in Sydney and Melbourne, but off a low base. The broker suspects it may take years to unwind current rental positions. Market incentives of 27% are now materially higher than both average portfolio incentives around 12% and expiring lease incentives around 16%. Any positives? Occupancy levels have stabilised at 94% after two years of decline and lease expiries across FY15-16 have fallen for all office A-REITs, which should be supportive of occupancy rates. Credit Suisse believes Cromwell Property Group ((CMW)) and GDI Property Group ((GDI)) have the greatest risk in this area. Within the sector, Credit Suisse prefers Mirvac and GDI over Investa Office Fund ((IOF)) and Dexus Property Group ((DXS)).

Given the year-to-date outperformance, which has reduced valuation upside and effectively priced in a lower-for-longer yield, Morgan Stanley has downgraded the sector to Cautious from Attractive. Also, earnings momentum is slowing and there is a slight deterioration in earnings quality. The broker believes growth prospects are fully priced and the most attractive stocks in the sector are Goodman Group ((GMG)), Arena REIT  ((ARF)), Lend Lease ((LLC)), Scentre Group ((SCG)) and Stockland, as each can develop its own product rather than compete for assets in a tightening yield environment.

Those A-REITs with a residential exposure are the most constructive in terms of outlook for Goldman Sachs, with NSW having the strongest outlook and Queensland improving. The broker deduces from developer feedback that the hurdle rates of return for residential land site acquisitions are now lower. This is attributed to the robust demand from buyers, particularly in the residential and industrial market, but also from low bond yields which are driving return requirements lower.

Goldman also notes growth is hard to come by. One-year earnings compound growth forecasts are 5.8% for the sector, but this is boosted by a spread of growth for certain stocks in the sector and lack of growth for many others. A recent trend the broker observes is the conversion of existing properties to higher and better use, particularly in residential markets. Those that stand out from a growth perspective are Federation Centres, Goodman, Dexus and Westfield Corp ((WFD)), while CFS Retail ((CFX)), Charter Hall Retail ((CQR)) and Shopping Centres Australasia ((SCP)) are at the opposite end of the scale.

The broker observes the sector is breaking up into three types, not necessarily split along segment lines. These are passive A-REITs, which tend to trade closely around asset values over the longer term. These stock tend to be relatively cheap or expensive versus the longer term average. The broker finds less value in this type of A-REIT than previously was the case, given their current high prices relative to long-term historical averages. The second type is structural recovery A-REITs, generally residential, which have been trading below levels implied by long-term average price/book value on their inventories. In this case, Stockland has reduced its impaired inventory overall, but increased the level of impaired stock to be developed rather than disposed of. Mirvac's key challenge, in Goldman Sachs' view, is how to balance the return on capital employed while delivering earnings growth off its strong base in FY14.

The third type is the fund manager A-REIT. Goldman finds the most opportunities in this type of stock. Charter Hall Group ((CHC)) and Goodman Group are the only two the market views as true fund managers but Goldman thinks Dexus and GPT Group are increasingly worthy of this designation, in the broker's opinion. Following the internalisation of management, CFX is another that has now increased non-rental income – to 8% of revenue. Of this type of A-REIT Goodman is the broker's key Buy call, although Buy ratings are retained for GPT and Dexus.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms