Stock Selection Key For A-REITs In 2020

This story features CHARTER HALL RETAIL REIT, and other companies. For more info SHARE ANALYSIS: CQR

Prospects exist for strong returns from the A-REITs in 2020 but brokers point out the secret is in stock selection.

-Cash flow, asset growth and sub-sector performance key in 2020
-Mixed views on outlook for residential A-REITs
-Industrial/office remain most in demand
 

By Eva Brocklehurst

They may be underperforming the rest of the market but Australian Real Estate Investment Trusts (A-REITs) have begun 2020 strongly, adding 6% in the first few weeks.

Official rate cuts anticipated in 2020 – JPMorgan economists forecast two – should drive further compression in required returns. Moreover, the broker suggests considerable acquisition capacity exists in many cases and the cost of capital remains competitive.

As global growth accelerates, Macquarie anticipates yields on 10-year bonds will increase to 2.5% in the US and 1.9% domestically over 2020. This is, in isolation, a negative for the A-REITs sector, given the negative correlation historically.

Nevertheless, the broker assesses yields under 2% domestically are still positive for A-REITs, and in this environment the fundamentals of the specific stock will come into greater focus.

Hence, a combination of earnings revisions, cash flow certainty, asset growth and sub-sector performance will be key to deriving returns from the sector, which is screening value, albeit skewed by retail A-REITs.

Half the sector sits in the retail segment, the broker points out, which warrants a higher yield or lower multiple, given structural headwinds continue. This will impact earnings and distributions in the medium term.

While Macquarie considers it too early to make a call on retail conditions, offshore retail property experience indicates the grocery-anchored malls have historically outperformed discretionary malls.

The broker has upgraded Charter Hall Retail ((CQR)) to Outperform from Underperform and Shopping Centres Australasia ((SCP)) to Neutral from Underperform.

Over 2019 A-REITs as a group returned 19.4%, Macquarie calculates, below the markets 23.4% and, as Australian 10-year bond yields fell post August, any earlier outperformance by A-REITs was more than reversed in subsequent months.

However, there were a wide range of returns, JPMorgan points out, from 55% for Charter Hall ((CHC)) to 2% for retail laggards such as Vicinity Centres ((VCX)) and Charter Hall Retail. The broker agrees stock selection will be most important in 2020 highlighting a preference, in fund management A-REITs, for Charter Hall over Goodman Group ((GMG)).

Residential

Macquarie's preferred segment is residential, given a supportive regulatory backdrop, low mortgage rates and favourable demand/supply dynamics. The broker prefers Mirvac ((MGR)), rated Outperform, in this area. Improving markets in residential along with earnings upside from the proceeds of the equity raising are expected to support a re-rating of the stock in the short to medium term.

In contrast, a more demanding valuation for Stockland ((SGP)) is already pricing in future residential upside, while there is downside risk to the company's retail book, which is 45% of capital. Hence, Macquarie has an Underperform rating.

Citi finds the residential business, as with retail, has been over-earning and there are a range of impediments weighing on the growth outlook, particularly for Stockland. While a residential recovery may be underway, a record FY19 is being cycled.

Stockland's residential earnings are expected to decline over the next two years as a result of the cycling of peak earnings, and despite the large fall in house prices. Citi maintains a Sell rating on Stockland. In contrast, Goldman Sachs notes the stock still offers a 4% 12-month total return at current pricing and maintains a Buy rating.

Office

Office rents are expected to remain subdued because of increasing vacancy rates in most markets, although asset value should underpin returns and Macquarie upgrades Dexus Property ((DXS)) to Outperform. Charter Hall Long WALE REIT ((CLW)) is also upgraded, to Neutral.

JPMorgan prefers Dexus Property over GPT ((GPT)) in the office/diversified A-REITs segment, highlighting the varied growth rates in industrial rents, ranging from 1% to 5%.

This remains the asset class most in demand from institutional investors as Goldman Sachs notes many are of the view that a further tightening of return hurdle rates over the next 12 months will drive valuation upside and, in turn, lift asset values.

This may even result in increased M&A activity as some asset-heavy A-REITs are taken private. Yet the offset will be the adoption of more realistic long-term rental assumptions, resulting in minimal net valuation moves.

In explanation, the broker points out that prime western Sydney and Melbourne logistics rental growth has failed to match inflation over the last 10, 20 or 30-year periods. Hence, there is doubt about the current rental growth of 2% per annum factored into valuations and whether it will be sustained over the next decade.

Goldman Sachs has upgraded Goodman Group to Neutral, assessing the stock is now fairly priced after a -4% decline over recent months. Charter Hall Social Infrastructure ((CQE)) is upgraded to Buy from Neutral.

The broker believes the weakness in the latter's share price has been driven by management changes and a potential change in strategy away from childcare. Although this is likely to remain a core holding in the portfolio, Goldman Sachs expects earnings growth will come through external opportunities including non-childcare acquisitions.

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