Differing Outlook Among Major A-REITs

This story features SCENTRE GROUP, and other companies. For more info SHARE ANALYSIS: SCG

-FDC earnings seem more valued
-More profit in retail vs office
-GPT, SCG better investment income
-IDR: weak tenant demand in Brisbane

By Eva Brocklehurst

As part of the merger with Novion, Federation Centres ((FDC)) is re-structuring its debt and hedges to ensure all debt will be at market rates. Comparing income statements across three other Australian real estate investment trusts (A-REITs) suggests to JP Morgan this will put the company’s cost of debt materially below its peers.

The broker analyses four large defensive plays in the sector in order to make comparisons – Federation Centres, Scentre Group ((SCG)), GPT ((GPT)) and Dexus Property Group ((DXS)). The main source of income is rent, with third party fees derived from managing assets, funds and developments. Expenses involve overheads and interest.

The broker assumes Federation Centres will end up with an average cost of debt of just under 4.0%. Allocating the same debt costs to the three other A-REITs would result in earnings upgrades for all three. Now, the broker is not suggesting breaking swap contracts – which is not value accretive – but what this does signal is the market is valuing the higher earnings and distributions that Federation Centres offers at more than its peers.

On another measure, JP Morgan finds Scentre Group generates twice the earnings per dollar of assets managed compared with the other three. This reflects the higher profitability implied in retail management – particularly shopping centres – over office management. Retail typically generates a full spectrum of fees while office is sometimes outsourced. Dexus Property has a high office exposure which means there is greater variance between its book value and cash flow, because of high incentives relative to retail. Its debt costs are well above market while operating costs higher than peers.

The broker expects Scentre Group to be more active on development as well in FY16. So, all up, this should mean Scentre Group is a higher value business. Yet, again, the market appears to ascribe more value to Federation Centres. On the expense side of the ledger, Federation Centres’ FY16 overheads only incorporate around 60% of the estimated merger synergies so overheads should be lower in FY17 and fall roughly in line with Scentre Group. This suggests to JP Morgan that Scentre Group is not getting any scale benefits.

JP Morgan also makes the observation that Scentre Group and GPT are generating better relative income from investment property versus book values compared with Federation Centres and Dexus Property, which appear to have more conservative or lagged valuations.

The pay-out ratios of all four are high, considering there are active developments to be funded. It is therefore likely, in JP Morgan’s view, that distribution policies will converge in the medium term and the high pay-out ratios will fall. On this measure, Scentre Group has flagged a reduction to 90% by growing free funds from operations (FFO) at a greater rate. Its FFO ratio is 99%. Federation Centres’ policy is now under review and it remains possible it will be scaled back from the current ratio above 100%. Dexus also has a comparable ratio over 100% while GPT’s is 98%.

JP Morgan retains Underweight ratings on both Scentre Group and Federation Centres. Neutral ratings are maintained for GPT and Dexus Property. The broker believes GPT and Dexus Property have the best relative earnings upside through reducing debt and extracting savings. GPT is considered the cheapest stock of the group.

Industria REIT ((IDR)) is now reporting its earnings as FFO, which is the standard measure across the sector. The company declared a second half distribution of 7.84c, below expectations, and also signalled the FY16 guidance of 15-15.8c, below the forecasts of both Macquarie and UBS. The FY16 guidance signals an FFO ratio of 95-100%. Office leasing has fallen short of expectations. The company stated in its latest update that there are no signs of improvement in either tenant demand or leasing terms in the Brisbane market and does not expect this situation to change in FY16. On the back of the disappointment, Macquarie downgrades to Underperform from Neutral. Target is $1.94.

UBS notes there was no comment on earnings, besides the downgraded distribution guidance, but the leasing update indicated only 400 square metres had been settled since December 2014. Activity levels at the Brisbane Technology Park remain low with the cause attributed to the downturn in the resources sector and the recent change in government. The stock is the broker’s only A-REIT under coverage that is trading below its net tangible asset value. UBS maintains capital flows for direct assets remain strong and may lead to corporate activity, although acknowledges the theme is overshadowed by the leasing risk in the business market assets. UBS retains a Neutral rating. Target is $1.98.
 

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