Charter Hall Ventures Into Hospitality

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This story features CHARTER HALL GROUP, and other companies.
For more info SHARE ANALYSIS: CHC
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

-Benefit from longer leases
-Reasonable total returns
-Large stake, elevates gearing
 

By Eva Brocklehurst

Charter Hall ((CHC)) in joint venture with HOSTPLUS, a superannuation fund, will acquire 54 hotels for $603m on a sale and lease back arrangement with Woolworths ((WOW)). Woolworths is the majority owner of Australian Leisure and Hospitality Group (ALH) which, in turn, is the largest and most profitable pub operator in Australia.

Macquarie observes that, after this transaction, Charter Hall has limited capacity for further co-investment without equity recycling. Earnings growth guidance for FY15 has been upgraded to the top end of the prior range of 5-7%. Macquarie estimates the transaction to be 3% accretive on a full year basis and considers it another example of Charter Hall's ability to partner with a domestic superannuation fund on a large scale. The portfolio offers an initial yield of 6.8% and includes Dan Murphy's and/or BWS retail tenancies. Dan Murphy's leases involve base rent plus a turnover provision.

The 50% equity commitment from Charter Hall to the JV is relatively large for the Australian real estate investment trust (A-REIT), and will be funded via cash and a $100m undrawn debt facility. Charter Hall typically takes a 10-20% stake. Key to the transaction is the beneficial increase in the weighted average lease expiry (WALE) which Charter Hall obtains for its on-balance sheet investments. WALE increases to 9.6 years from 7.5 years with this venture and property investment income, as a portion of total earnings, to 67% from 61%.

Significantly, the transaction is in line with Charter Hall's strategy to increase exposure to longer lease terms and the extended WALE shores up the predictability of future earnings. JP Morgan notes that to facilitate this, Charter Hall has taken the option to expand the balance sheet at a relatively low yield and higher level of co-investment than usual. However, as BA-Merrill Lynch points out, this 50% co-investment should not be taken as a given for the level of equity participation in future ventures. 

Merrills compares the initial yield of 6.8% to the 6.42% for ALE Property ((LEP)), landlord to 86 ALH pubs. On that basis the transaction appears fair, with 26% of the income derived from Dan Murphy's and BWS. Charter Hall's returns will be boosted by funds under management (FUM) fees but no property management fees will be generated, given the triple net lease structure whereby capex is borne by the tenant. The transaction will use the majority of Charter Hall's excess liquidity and bring gearing to the top end of the target range. Nevertheless, management is confident of recycling capital to reduce leverage by the end of FY15. This transaction will rank third largest in the A-REIT's investment portfolio but, as Deutsche Bank observes, Charter Hall has demonstrated an ability to sell down relatively high initial stakes in newly formed vehicles.

Based on historical norms, the yield could be viewed as reflecting a portfolio premium. JP Morgan estimates that a 10-year unleveraged internal rate of return for the joint venture's ALH portfolio is likely to be 8.75%-9.25%. Overall, the broker believes this is a reasonably compelling total return. The only distinctive feature of the portfolio is the proportion of assets in regional locations – 35%. At a less favorable point in the property cycle, JP Morgan suspects there could be a greater risk of some cap rate softening – book value versus income – for these assets.

Strategically, UBS believes the transaction is ideal, as it extends WALE with a strong credit quality tenant and a high quality capital partner. Still, the broker is mindful of the size of the stake and the increased leverage, which increases Charter Hall's reliance on external equity in the short term and tilts the stock back towards property ownership. UBS observes real estate fund managers are in a sweet spot at present as asset values are generally increasing and there is continued support from existing and new wholesale investors.

Hospitality is a new asset class for Charter Hall but Credit Suisse notes the risks are largely alleviated by the 20-year lease terms and triple net leases. Again, comparisons show ALE has low income volatility and stable cap rates, with only 80bps variance since 2005. Charter Hall's cap rate – 6.8% – appears high against ALE's – 6.4% – but then Credit Suisse notes ALE's assets are materially under-rented. Moreover, Credit Suisse observes, after this transaction, Woolworths still has more than $1bn in net property acquisitions accumulated since 2008, which may provide more growth for the Charter Hall JV.

Earnings will be affected from FY16 as Charter Hall begins to pay tax but, given the ability to frank dividends, domestic investors will be entitled to a franking credit. A lower value will be attributed to these credits by the market in Macquarie's opinion as not all investors will be able to utilise them. Macquarie assumes an 8% group effective tax rate from FY16.  Deutsche Bank highlights a three-year compound earnings growth rate of 3.7%, which reflects assumed incremental tax headwinds from FY17.

ALH was acquired by Woolworths (75%) and Bruce Mathieson (25%) in 2004. Since 2010 Woolworths has divested and leased back more than $2.8bn in property assets.

Charter Hall has a consensus target of $4.46 on the FNArena database, signalling just 0.7% upside to the last share price. There are three Buy ratings and four Hold. Distribution yield on FY15 and FY16 forecasts is 5.4% and 5.7% respectively.
 

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