Where Best To Find Yield

This story features MIRVAC GROUP, and other companies. For more info SHARE ANALYSIS: MGR

-Office stands out among A-REITs
-Are A-REITs becoming expensive?
-Stable cash flow supporting utilities
-Infrastructure retains high IRR
 

By Eva Brocklehurst

Ahead of the August results brokers are reviewing the returns for various sectors which are described as yield performers in the face of a weak economic outlook, low bond rates and low inflation.

UBS calculates that in both US dollar terms and local currency, A-REITs have been the best performers in the year to date. The broker is overweight Australian Real Estate Investment Trusts (A-REITs) and believes the sector's FY16 dividend yield of 4.2%, or 4.5% excluding Westfield ((WFD)), is sustainable, based on an 85% earnings pay-out. Retail and office A-REITs are considered well positioned to deliver modest rental growth over the next 12 months.

The Sydney office cycle is being underwritten by withdrawals and low supply, UBS contends, and vacancies are expected to trend below 5% by the end of 2018. With vacancies below 5% rental growth is expected to be 5-15%. On the other hand, vacancies are increasing nationally, the broker acknowledges, underpinned by Brisbane and Perth, and forecast to hit 11.6% by December.

Tightening yields have induced a supply response in the Sydney CBD office market, Credit Suisse notes. Analysis suggests developers can build for $16,000/sqm compared with prevailing values of around $22,000/sqm. This suggests the potential to undercut landlords via pre-commitment deals on lower effective rents.

The view is underscored by recent planning strategies in Sydney's CBD that have shifted heavily in favour of commercial development over residential. Limited medium-term supply is generating interest in the rental growth prospects, but Credit Suisse questions the sustainability of the prospects. Rentals are being inflated by incentives, the broker suspects, providing benefits to developers.

The broker's order of preference among office A-REITs is based on relative value and sustainable risk-adjusted medium-term growth, with particular regard for distribution growth underpinned by operating cash flow.

Mirvac Group ((MGR)) is the top preference, given the attractive asset quality, geographical mix, recurring income security and strong relative growth, but the broker recently downgraded to Neutral from Outperform, given the stock has run through its upgraded target price of $2.15. Investa Office ((IOF)) is also considered to have substantial leverage to upside in the medium-term Sydney office segment. The best performing CBD A & B grade segments account for 52% of the stock's total asset base compared with 17% on average for its peers.

Morgan Stanley expects the results season will reveal improving net operating income for office A-REITs and improved settlement and earnings certainty to those exposed to residential markets. The broker envisages a tactical opportunity in Mirvac, Stockland ((SGP)) and Lend Lease ((LLC)) heading into the results.

Morgan Stanley considers its 4.6% one-year distribution yield and 3.9% free funds from operations growth estimates for the sector are defensive. Yet, after outperforming in the year to date circa 15%, A-REITs are becoming increasingly expensive versus other yield sectors, the broker maintains.

The flattening in the slope of the yield curve should provide further support but Morgan Stanley is increasingly concerned that the accommodative environment could mean a lack of focus by companies on sustainable growth initiatives, such as reducing costs and cleaning up portfolios, in favour of acquisition-led accretion.

Goodman Group ((GMG)) remains one of the broker's top picks, given its diversified business model and superior growth. A guidance upgrade may be forthcoming from GPT Group ((GPT)), on a strong results from its funds management division, but with limited news on efficiencies, increasing developments and recovery in re-leasing spreads, the broker retains an Underweight rating.

Morgan Stanley envisages 10-year bond yields will fall to 1.5% by March 2017, down another 50 basis points from current levels. This should flatten the yield curve and continue to drive outperformance in the A-REIT sector. Further rotation into A-REITs could be forthcoming throughout the earnings season.

Retail A-REITs have traditionally been defensive but the broker expects the challenged outlook for the consumer will mean retailers become more selective. This is expected to drive increasingly defensive development capex and decreased rental/re-development returns, putting pressure on pay-out ratios.

Meanwhile, the improving market fundamentals of the office segment will lead to lower capex and drive an increase in sustainable distribution growth, the broker maintains. In sum, Morgan Stanley has Overweight ratings for Dexus Property ((DXS)) and Investa Office, and remains Underweight on all pure-play retail A-REITs.

Low inflation rates are negative for utilities with unregulated assets and regulated assets already into their 5-year regulatory periods, because inflation-linked revenues are lower. Nevertheless, Citi still expects that the search for yield will support the share prices of regulated utilities, given their long-term stable cash flow and distributions.

Among utilities and infrastructure funds, APA Group ((APA)) is now considered to have the most potential to materially grow distributions, but a weaker growth outlook and lower inflation, with the risk to short-term services revenue, could mean distribution growth is lower than some expect. Citi's preference is for DUET ((DUE)) followed by Spark Infrastructure ((SKI)), and then APA, followed by AusNet Services ((AST)).

Shaw & Partners also ranks three listed infrastructure stocks by their internal rates of return (IRR) and forecast distributions. The broker acknowledges the concessions vary, but believes the analysis does illustrate the opportunity, based on a belief the sector as a whole will trade on a forecast yield. The broker rates Macquarie Atlas ((MQA)) as a Buy, as it has the highest rate of return at 8.0%. Sydney Airport ((SYD)) and Transurban ((TCL)), both Hold rated, follow with 6.5% and 5.2% respectively.
 

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