As Good As It Gets For Goodman?

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Leading A-REIT Goodman Group has posted yet another solid result, shining among peers. But how long can the tailwinds last?

– Another year of guidance-beating earnings
– Plenty of cash to deploy
– Signs of margins easing
– Signs of growth rate abating

By Greg Peel

There was no surprise among analysts of Australian real estate investment trusts (REIT) when Goodman Group ((GMG)) announced FY16 earnings growth of 7.8%. Management most recently upgraded guidance to 7.5% growth, but as Macquarie points out, the trust has begun each of the last three years with guidance of 6% growth and delivered 7.4%, 6.9% and 7.8% respectively.

For FY17, Goodman has guided to 6% earnings growth.

And it’s difficult to see how that will not be achieved. As Macquarie notes, property investment revenue is largely contracted, management earnings are predominantly recurring and the most unpredictable part of the business – property development – commences with $3.4bn of work in progress, underpinning at least half of development earnings required to meet the 6% earnings growth target.

Analysts like Goodman’s structural story. The REIT is focused on logistics, developing properties to support more modern and efficient distribution networks for the world’s growing focus on e-commerce. And Goodman’s developments span the globe.

Alongside $3.4bn of development work in progress is $34.1bn of assets under management and a “world-leading” funds management platform, as Morgan Stanley describes it. At 11.8%, gearing is low, and Goodman boasts $10.3bn in undrawn debt, equity and cash, with cash sitting at $1.3bn.

In this age of ultra-low global interest rates, cash generates very little return. But low interest rates also mean strong demand for yield elsewhere, and thus ever higher property prices. Goodman could decide to return cash to shareholders via some form of capital management, and many a shareholder would thus be pleased, but as Macquarie calculates, $1bn of investment in new property generating a 6% return would be around 5% earnings accretive, and gearing would still remain comfortably under 20%.

Hence there is incentive to keep plugging on. But how long can it all last?

Let’s take the analogy of Sydney-Melbourne property prices. For the past few years these have soared, prompting concerns of a housing bubble, as investors have sought yield through property when very little yield is available from other investments of similar low-end risk. While fresh APRA regulations have forced investors to back down somewhat this year, further RBA rate cuts have ensured owner-occupiers have picked up the slack and property prices just keep on rising.

For investors, yields are falling with each higher price paid, given low wages growth ensures rents are not keeping pace with property values. At some point, a line in the sand will be reached on property value, relative to supply. But economists are predicting further RBA rate cuts so the end may not be in sight just yet.

Around the globe however, how much room is there for even lower interest rates? Japan and many European countries already have negative rates, and powerhouse economies such as Germany have a near zero rate. There is a possibility US rates will begin to rise. Central banks have reached the point at which they have to tell their respective governments there’s little in the way of monetary firepower left, and it's time fiscal policy took the baton.

Therefore, how much longer can the values of Goodman-style properties keep rising? In FY16 asset values continued to rise across the globe, with the exception of a Brexit-hit UK and floundering Brazil. Cleary the structural story of e-commerce and logistics will continue to support demand, but at what point does value peak?

Just as the yield on Sydney investment property is falling as rents fail to keep pace with value, Goodman’s rental income to asset value measure is now also falling. In REIT terms this is known as capital, or “cap” rate compression. Falling cap rates are representative of rising asset values, and each time Goodman develops a property in a rising value market it delivers a margin on the cost of building.

Ord Minnett has looked at yield on costs. In FY16 this was a very healthy 21% but this has compressed from 25% and is actually the lowest it’s been since 2009. If cap rates stop compressing – property value growth slows against rent growth – Goodman’s development margins will moderate.

Goodman also takes performance fees on delivering development returns. Analysts consider this element of the trust’s earnings to be “low quality” despite the quantum of earnings performance fees are currently generating, given these will be the first to give way when the tailwinds start to ease.

UBS further points out that while significant development margins still remain, Goodman’s development work in progress declined 2% in the second half – the first fall in almost five years. Development yield has fallen to 7.8% from 8.3%. This still compares favourably to an average cap rate of 6.4%, but as UBS puts it, are development yields now “maxing out”?

Perhaps the trends are suggesting it might be time for Goodman to indeed look at rewarding shareholders with capital returns rather than pushing that little bit too far on development. But unfortunately it’s not that easy. Ahead of rewarding shareholders, Goodman has to service its debt, and clearly there is  risk in allowing debt to rise too far if indeed we are starting to see signs of an easing market, just as an overstretched mortgage is a danger in a housing bubble.

Around 85% of Goodman’s debt is in bonds and US private placements, which cannot be repaid early. Therefore, Goodman must continue to deliver earnings growth ahead of the opportunity to pay down debt, and for that it needs to deploy its cash, not give it away.

The music has not yet stopped. Indeed, analysts see no reason FY17 won’t be another year in which Goodman starts with 6% earnings growth guidance and ultimately delivers something higher. By FY18 however, well, maybe those numbers will start to pull back.

Which then brings share price into perspective. Of the six brokers in the FNArena database covering Goodman, four rate the stock a Hold or equivalent. Only two are sticking with Buy. Goldman Sachs – not a database broker – also has a Hold rating.

Macquarie is sticking with Buy (Outperform). The broker’s argument is based on the premium the market is applying to predominantly rent-collecting A-REITs. In arriving at a $7.47 target for Goodman, Macquarie is assuming an 8% premium. Were 15% assumed, that value would be $7.80. And Macquarie can’t get past Goodman’s low gearing and cash balance and the opportunity that provides for further near term earnings growth.

Morgan Stanley is also persisting with Buy (Overweight). However in the analysts’ own words:

“We walked away from the FY16 results presentation thinking that growth will become harder from here, there will be fewer catalysts or surprises to attract the marginal investor, and we expect scrutiny around the capital management strategy, growth drivers and quality of earnings (more volatility, more performance fees) to intensify. Whilst we are comfortable with our A$7.70 price target, we expect the delta [pace of growth] in NAV [net asset value] and cash flow valuations to slow down from here.”

Morgan Stanley’s opinion echoes those of brokers with Hold ratings.

The consensus price target in the FNArena database is $7.39, suggesting 0.8% downside from Friday’s closing price, in a range of $7.20 (UBS) to $7.70 (Morgan Stanley). The consensus FY17 dividend yield is 3.4%.

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