-Retail digital income increasing
-Higher bond yields a negative
-Mall quality equates to sales
-Conditions ripe for consolidation
 

By Eva Brocklehurst

Macquarie has taken a look at non-traditional sources of income for retail Australian Real Estate Investment Trusts (A-REITs), triggered by the announcement that Scentre Group ((SCG)) has taken its shopping centre signage provision in-house. The broker observes the retail A-REITs are increasingly intent on driving a digital strategy via screen advertising in malls, free WiFi - used to track shopper foot traffic - as well as improved websites and smart phone applications. While it remains difficult to quantify, these sources of income are expected to increase as a proportion of gross revenue.

Digital advertising allows for more and varied content compared to a traditional display but with this increased revenue comes increased capital expenditure. Macquarie does not believe the revenue opportunity will outweigh the other opportunities that come from the structural changes affecting retail landlords, such as elevated supply, downside risk to tenant margins when factoring in a lower Australian dollar, and a subdued performance from key categories such as apparel. Hence in the segment, the broker prefers Westfield Corp ((WFD)), Goodman Group ((GMG)) and GPT ((GPT)).

What would the impact of higher bond yields be on the retail A-REITs? The correlation is negative and Macquarie continues to expect modest like-for-like growth for the retail landlords in the foreseeable future, with compressed dividend yields and the relativity to bond yields likely to narrow. Changes to exchange rates are also expected to be a key feature of the sector. This suggests to Macquarie that many of the basic rent-collecting A-REITs will fall short of delivering an adequate total return for investors.

In this scenario, Scentre Group remains a key Underperform recommendation as the pay-out ratio is likely to ease over time, in Macquarie's view. In contrast, the lower Australian dollar is expected to benefit Westfield and the broker retains an Outperform rating on this stock, underpinned by potential for a further value-affirming restructure, M&A and a strong US retail outlook relative to Australia.

JP Morgan suspects a strong relationship between shopping centre quality and sales growth as landlords race to redevelop their centres. When cap rates fall - the ratio of asset value to producing income - hurdle rents also fall and the feasibility of any given development improves. The role of the anchor tenant in these redeveloping shopping centres is diminishing, the broker maintains, with the focus now on international "mini majors" up-market casual dining, retail services and technology. With this in mind, JP Morgan considers Scentre Group is the best placed, as it has the highest quality portfolio and best development track record.

The broker has also found that Stockland's ((SGP)) portfolio is under rented in this segment and undervalued relative to its productivity. Therefore, that company should be well placed to deliver strong net operating income and capital growth relative to peers.

JP Morgan has also reviewed the Investa Property Group portfolio and management platform, given Morgan Stanley's recent announcement it will commence a sale process. The broker estimates the portfolio has 75% Sydney CBD exposure and over the next three years there will be 35% of total space expiring. Investa Office Fund ((IOF)) has last right of refusal to acquire the rights to the management platform. Other than Investa Office, JP Morgan considers Charter Hall ((CHC)) to be well placed to accommodate the platform.

Analysis shows a joint venture acquisition of the portfolio at current security prices would be accretive to net tangible assets and free funds from operations, but the low yield would be potentially dilutive to cash flow forecasts. The degree to which an acquisition would require a material increase in gearing is critical, in JP Morgan's analysis.

Conditions are good for consolidation in retail property globally, Morgan Stanley observes. This comes with structural change in retailing, unprecedented access to capital and, for most, reduced development activity. Portfolios appear to the broker to have moved to a smaller footprint around major gateway cities, providing greater growth potential as retailers look to exit smaller markets.

Although conditions look conducive to cross border mergers and acquisitions, the broker observes there are obstacles, including family ownership and the complexities of scrip-based consideration. Moreover, cost synergies may be limited. Overall, the broker considers the segment is fully valued. If Westfield can execute on non-core asset sales and its development pipeline then Morgan Stanley considers its portfolio is likely to be the most geographically attractive over the next five years.
 

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-Residential best performers
-Focus on better quality assets
-Tighter cap rates lead to lower rents?
-Regional mall pay-out ratios to fall?
 

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) completed eight straight months of outperforming the S&P/ASX200 in February. JP Morgan observes a select few were still running hot, including Aveo Group ((AOG)), Cromwell Property ((CMW)) and Mirvac ((MGR)). Residential stocks were considered the best performers in the reporting season and the broker retains a preference for this segment over the pure office and retail landlords. Hence, key picks are Stockland ((SGP)) and Mirvac, as both are leveraged to lower interest rates and a resilient housing market.

Portfolio repositioning is now a strategy that the sector is seen embracing, which involves getting out of lower growth assets and reinvesting or developing better quality assets. JP Morgan observes strong transaction activity and a narrowing of cap rates - the ratio of asset value to producing income - are underpinning this strategy, particularly in terms of developer margins. The broker highlights Westfield Corp ((WFD)) and Scentre Group ((SCG)), which have backed away from introducing new capital partners into their best assets and/or developments, possibly indicating further upside in asset values in the cycle is expected.

Goldman Sachs observes A-REITs made a strong start to 2015 and with interest rates set to remain lower for longer, and the spread of property yields to bond yields at an all-time high, demand for these equities should remain robust. The broker also notes positive asset revaluations are being driven by cap rate compression, while the cost of debt is falling, residential conditions remain robust and the organic growth outlook is muted. Of fifteen under coverage, Goldman observes eleven A-REITs reported stronger-than-forecast results, while seven upgraded or tightened full year guidance. The broker finds relative value still exists in Mirvac, Goodman Group ((GMG)), Dexus Property ((DXS)), GPT ((GPT)) and Hotel Property ((HPI)).

Most A-REITs are trading well above Deutsche Bank's fundamental valuations. The broker envisages scope for only 25 basis points of sustainable tightening in cap rates and, after adjusting for the prevailing level of lease incentives for each asset class over time, accepts apparent mispricing is reduced meaningfully.

That said, assuming a "lower for longer" interest rate environment, consensus expectations suggest tighter cap rates will flow to higher valuations and, subsequently, higher prices for A-REITs. Deutsche Bank's analysis suggests differently. The broker uses 100 basis points of sustained cap rate tightening as an example, showing it would reduce effective replacement cost rents by up to 29% and drive net operating income declines for most of the sector. Hence, quality portfolios matter more than ever.

The broker concludes that while cap rate tightening is initially positive for real estate values, ultimately it means tighter exit cap rates and, with lower funding costs, this would enable developers to make projects seem viable with lower rents. In a period of subdued tenant demand there will always be developers sacrificing a super margin in order to get these developments leased up as quickly as possible. This scenario suggests to Deutsche Bank that market rents will come under downward pressure over time. In turn, so will income.

This is particularly the case in office and CBD projects, but the broker suspects that if the same feasibility analysis were run on other asset classes, the outcome would be similar for neighbourhood retail - especially as supply in this area is driven largely by the major tenants. The broker hastens to point out that this extent of market rent decline is not forecast and another 100 basis points of cap rate compression is also not likely to be on the cards. Simply put, cap rate compression driven entirely by lower return requirements does not necessarily have positive ramifications down the track.

The class that performs the best in this scenario is regional malls. When development does occur in this segment it is nearly always undertaken by the long-term owners, which are not likely to undermine rentals at their existing assets. Hence, Scentre Group, Westfield and Goodman would be relative winners. The losers in this scenario? Those with only "average" quality assets and limited development capacity. On the basis of the feasibility analysis and after a strong price performance, Deutsche Bank downgrades Dexus, Investa Office ((IOF)), Cromwell, Charter Hall ((CHC)) and Novion ((NVN)) to Sell from Hold and Stockland to Hold from Buy.

UBS considers, post reporting season, residential is the pick of segments, with both Mirvac and Stockland refining guidance upwards, supported by lower interest rates. The broker observes office shows no underlying growth while regional retail is picking up. This broker, too, notes subtle changes in strategy, as both Scentre and Westfield move away from a capital light model, choosing to reinvest in their best assets and hold onto them.

Regional mall pay-out ratios look set to decline as UBS notes they are the last remaining asset class where distributions are greater than free cash flow. This will affect Scentre and the, potentially, merged entity of Federation Centres ((FDC)) and Novion. UBS is also somewhat alarmed at the upward trend in corporate costs and will be watching this area closely at the August results.
 

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-Residential, regional retail preferred
-Sector fully priced but can rally still
-More narrowing of cap rates priced in

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) continue to outperform the rest of the market, assisted by record low 10-year bond rates. UBS finds it easy to imagine the A-REITs will outperform again this year on the back of low global yields and downward pressure on inflation from lower oil prices. Add in cheap finance, a lower Australian dollar and potential corporate activity and this bullish position fast becomes crowded.

The broker highlights the fact the sector is trading at a 2.8% premium to valuation while acknowledging, if the long bond remains at current levels, there is further room for a sector rally. By segment, UBS prefers residential and regional retail over industrial, non-discretionary retail and office. The main change to the broker's recommendations is the growing conviction that the residential cycle will be stronger for longer, with a pick-up in discretionary retail. Hence, UBS favours the residential segment this reporting season, reflected in stocks such as Mirvac ((MGR)) and Stockland ((SGP)). The broker expects FX benefits will support Westfield ((WFD)) and Scentre Group ((SCG)) over the office A-REITs.

The sector is fully priced in JP Morgan's opinion too. It is trading around 6.0% above the broker's average price targets with the average distribution yield at record lows of 4.8%, despite still exceeding the long-term bond rate by 240 basis points. Last month, in large cap stocks, outperformance was led by Dexus ((DXS)), Novion ((NVN)) and Westfield. Notable underperformers were Lend Lease ((LLC)), Hotel Property Investments ((HPI)) and Astro Japan Property ((AJA)). Over January there were both acquisition and equity raising activities with two major asset sales, while two portfolios are also being marketed, from Mirvac and US-listed Equity Commonwealth. JP Morgan's top pick remains Mirvac, which is trading at a perceived 6.0% discount to fair value.

Morgan Stanley remains attracted to the industry because of the positive earnings momentum, as debt costs step lower and multiples expand in response to record low bond yields. Mirvac and Stockland have underperformed the rest of the sector in the past six months, in the broker's opinion, despite the improved fundamentals for the residential sector. Morgan Stanley expects the latest rate cuts could act as catalysts to reverse this underperformance. An improving Sydney office market could provide the scope for upside while retail sales figures suggest there will be little change to negative re-leasing spreads in that arena.

Subdued growth for FY15 is forecast for SCA Property ((SCP)) as the majority of the Woolworths ((WOW)) rent guarantees rolled off in December 2014. However, Deutsche Bank expects a rebound in FY16, driven by specialty vacancy rates falling to 5.0%. The broker expects Cromwell Property's ((CMW)) growth will largely be driven by the acquisition of Valad Europe while Charter Hall Retail's ((CQR)) transition to a domestic vehicle in FY15 will be weighed down by the dilution from offshore asset sales. The broker expects first half earnings will be slightly lower because of the rolling off of higher returning contributions from Europe. While Charter Hall Retail has guided to underlying Australian growth of 8.0% or more the broker estimates around 3.0% of this relates to he redeployment of offshore sales proceeds.

Those A-REITs best placed to positively surprise in terms of lower funding costs are Investa Office ((IOF)) and Hotel Property, in Goldman Sachs' view. Falling petrol prices and cycling of new government legislation have resulted in strong gaming profitability in Queensland where Hotel Property's hotels are located.

Goldman Sachs also observes that over the last 12-18 months, traditional direct property asset classes such as office, retail and industrial, have witnessed an influx of demand from institutional capital, both from locals and from offshore. The broker highlights that 2014 was a record year in terms of transaction value. The flow-on effect of the strength of direct markets and the appetite for traditional property in Australia has resulted in the compression of yields and capitalisation rates - the ratio of producing income to asset value. In the case of office and retail, and Goldman notes this cap rate compression has occurred without any underlying income growth.

The broker believes cap rates can narrow further, and that the equity market appears to be pricing this in, with all stocks ex Dexus trading at implied cap rates that are lower than those stated back in June 2014. Goldman believes another 25 basis points of official rate cuts are on the table in August after this month's cash rate reduction to 2.25%. Hence, A-REITs that may positively surprise in terms of lower funding cost include Investa, Charter Hall Retail and Hotel Property, all at the lower credit quality end of the spectrum.
 

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-Counter bid hard to envisage
-Views differ on which entity gains
-Lack of cash for Novion holders
-Potentially third largest A-REIT
 

By Eva Brocklehurst

Novion ((NVN)) and Federation Centres ((FDC)) have put the cat among the Australian real estate investment trusts (A-REIT) by announcing plans to merge. Each Novion security will be offered 0.8225 Federation Centres securities, implying a value of $2.55 for Novion stock, a 10% premium to the prior close.

Brokers are now speculating whether others in the sector may circle, although they acknowledge a counter-bid would be challenging as the deal has support from Novion's major shareholder, Gandel. While there is strategic merit, the synergies are overstated in Credit Suisse's view. The broker considers the deal is more favourable for Federation Centres as its asset base will improve, while Novion increases its exposure to more structurally challenged sub-regional assets. Federation Centres is also taking a calculated risk in Morgan Stanley's opinion, as its risk profile will increase with the transaction. The broker suspects the deal could nevertheless drive a wave of interest as the sector warms to the idea of creating scale and global relevance.

This is Groundhog Day in Deutsche Bank's view. A return to 2003 when scale, cost synergies and diversification were the default rationale for such mergers. Given the premium inherent in Federation Centres' proposal, and the support from Gandel, the broker considers it unlikely a competing bid will emerge. Deutsche Bank differs from other brokers in that it regards the earnings accretion for Novion investors is more material, offering a superior medium-term growth profile versus that of the standalone entity.

The benefits for Federation Centres on the other hand are less clear, on current assumptions. Deutsche Bank's initial estimates suggest it to be value destructive by around 10%. Management estimates earnings accretion is 5.8% on a FY15 pro forma basis, but Deutsche Bank suspects this would decline over the medium term as Novion's lower growth profile dilutes the benefits.

JP Morgan takes the opposing tack, believing the rationale for Federation Centres is clear but whether it is the best possible outcome for Novion remains to be seen. The broker's sticking point is the lack of a cash reward for Novion security holders. The offer is fully comprised of FDC scrip. JP Morgan considers this lack of cash opens the door for other interested parties but acknowledges FDC has a first mover advantage. As is usual in real estate deals, the broker observes, there are minimal revenue synergies. Cost savings underpin the earnings accretion from the merger.

Furthermore, Macquarie observes a large portion of this earnings accretion arises from the refinancing of all debt facilities, which could have been done in the absence of the proposed merger. The deal's rationale, in this broker's opinion, is based on Federation Centres being able to draw on the development experience of the Novion team, along with enhanced scale. Macquarie will look for further details in support of the deal but suspects that some of the value options that are expected to ensue would have been available to either entity on a standalone basis.

Moelis believes the merger is, at best, neutral for Federation Centres and dilutive for both. The majority of the initial synergy and interest savings are transferred to Novion unit holders through the merger ratio. The broker envisages a holder of FDC units needs to balance potential longer term scale with the difficulties of growing a larger vehicle. Moelis is not convinced that Federation Centres would be able to capture the necessary benefits to justify the merger and downgrades to Sell from Neutral on the news.

In regard to a new bidder emerging, Moelis finds it difficult to justify why a direct property buyer would pay the premiums to net tangible assets inherent in these vehicles. Hence, a rival bid would need to be from another listed entity using scrip and this is considered unlikely. There is also the $40m break fee.

Goldman Sachs estimates, should the merger be implemented, the group would become the third largest A-REIT within the S&P/ASX 200 index. It would manage or own in excess of $22bn in assets across 102 shopping centres and become the largest landlord in Australia to tenants Coles ((WES)) and Woolworths ((WOW)). Goldman Sachs expects the portfolio would include some competing assets which management may look to dispose of via a joint venture or wholesale vehicles.

The broker also observes there are no recent precedents for such a merger, as the 2004 attempt by Lend Lease (LLC)) and GPT ((GPT)) was unsuccessful. Goldman retains a Neutral rating on both stocks, expecting the market will be wanting more information at the upcoming results.

At this juncture FNArena's database reveals two Hold ratings and three Sell for Novion and two Buy, two Hold and two Sell for Federation Centres. The consensus target price for FDC is $2.78, suggesting 9.7% downside to the last share price. Dividend yield on FY15 and FY16 forecasts is 5.4% and 5.7% respectively. For Novion the consensus target at $2.26 suggests 10.4% downside to the last share price and the dividend yield on FY15 and FY16 forecasts is 5.3% and 5.5% respectively.
 

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-Accretive but increases risk profile
-Replacing domestic leasing gaps
-Is this a return to 2005?
 

By Eva Brocklehurst

Cromwell Property ((CMW)) has sparked interest with the acquisition of a European property funds manager, Valad Europe, for $208m, which will be funded from the issue of a EUR150m convertible bond.

Macquarie questions the transaction in that a lack of opportunity in Australia is not necessarily a good reason to go seeking potential offshore. The broker observes many Australian real estate investment trusts (A-REITs) have spent the last five years divesting offshore exposures which were taken up ahead of the global financial crisis. The company's risk profile has changed markedly with the convertible bond and the introduction of currency risk via the AUD/EUR rate. Deutsche Bank also highlights the increased financial and business risk and is not attracted to to the transaction, believing it does not add to the stock's appeal.

The transaction is estimated by Macquarie to be around 10% accretive to FY16 earnings on a full year basis, prior to any conversion assumptions about the new convertible bond instrument. This reflects the high yield on the Valad business and the 2.375% coupon payable on the convertible bond. Deutsche Bank also calculates earnings accretion at around 11%. Both brokers note the company has made a more conservative 5.0%-plus estimate for earnings accretion, given there is no FY16 guidance.

Deutsche Bank suggests the company's forecasts imply de-gearing, given that will move to around 45% after this transaction, up from 37% last June. Cromwell divested around 15% of its asset base in FY14 and this is expected to continue. Macquarie notes the company was intent on de-gearing last year as it indicated asset values were becoming too elevated in Australia. Also, the broker warns about the potential conversion of the bond, as this would be dilutive to earnings. Cromwell has assigned a low probability of conversion in its forecasts but, nevertheless, the risk exists.

The transaction was likely undertaken in part to shore up earnings in the outer years to cover known lease expiries such as the Tuggeranong Office Park in the ACT, which is around 9.0% of group income by Macquarie's calculation. Brokers question the added complexity in seeking to replace domestic leasing gaps with European funds management earnings. Moreover, Macquarie suspects the company may hold its distribution below the trajectory for earnings growth, given capex requirements for the portfolio and the leasing uncertainty. The broker also understands Cromwell will leverage the new platform with South African investors who are looking for exposure in Europe.

While the foray into Europe may not be as aggressive as the headlines suggest, for Deutsche Bank it is tinged with deja vu. The broker recalls Australian developers and fund managers scouring the world in 2005 for accretive bolt-on acquisitions and gearing up their balance sheets. The broker acknowledges two key differences with the Valad Europe acquisition compared with most of the deals done overseas by A-REITs in 2005-07. Cromwell is not deploying a material portion of its balance sheet to European real estate thus far, and the platform is being acquired for around 6.4 times FY15 forecast earnings compared with the multiples that ranged from 8.5 to 12 times for European funds management platforms acquired in 2005-07.

Deutsche Bank also does not expect other A-REITs will follow suit. The likes of Goodman Group ((GMG)), Stockland ((SGP)) and GPT ((GPT)) still have boards with memories of the pain that ensued in 2008-09 from aggressive overseas expansion, rich acquisition pricing and excessive leverage. Moreover, the registers of A-REITs are now more skewed towards global investors and the appetite among these investor bases for overseas acquisitions is limited. There is also far less evidence that the sector is under pressure to keep up with the broader market's growth outlook, given this is muted.

FNArena's database contains one Hold rating and two Sell ratings for Cromwell. Consensus target is 95c, which suggests 9.2% downside to the last share price. Dividend yield on FY15 forecasts is 7.6% and on FY16 7.7%.
 

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-Bumper year for A-REITs
-Supported by low cost of debt
-Recovery in Sydney, Melbourne CBDs
-Rental growth weak
 

By Eva Brocklehurst

Australian real estate investment trusts (A-REITs) continue to perform strongly. With yield spreads to direct property investment at near 20-year highs, a lower-for-longer interest rate outlook and strong transaction evidence, a narrowing of cap rates - book value versus the income produced - is expected, as properties are re-valued for December 31 reporting purposes.

December is historically the strongest month of the year, with Goldman Sachs noting a positive absolute performance in 17 of the last 22 years for the month. Historically, December provides a 1.8% excess return on the weakest month, January, despite some breaking down of the trend in the past few years. The broker consider 2014 is on track for a record year in terms of direct property transactions by value. A-REITs remain a strong performer on a global comparison, behind both US and Chinese developers. Value is scarce, in the broker's opinion, but it can be found in Mirvac ((MGR)). Goldman Sachs also prefers Dexus ((DXS)) and Goodman Group ((GMG)).

Macquarie believes the outlook for further cap rate compression in the CBD office market is good. The cost of real estate debt is lower, because of reduced cash rates, low bond yields and lower debt margins. The investor profile has also broadened, with foreign buyers joining domestic pension funds. The broker retains Outperform ratings for GPT ((GPT)) Investa Office ((IOF)) and Charter Hall ((CHC)). An Underperform rating is attributed to Cromwell Property ((CMW)), given its relatively low exposure to the Sydney CBD and significant leasing risk in other office markets such as Brisbane and Canberra.

The withdrawal of office space from the Sydney market via conversion to other uses, namely residential, hotel or retail, should help vacancy rates but Macquarie is mindful new supply is also coming to market, with large projects such as the Barangaroo towers and 200 George St developments. The broker's mid case scenario calculates vacancy rates will fall to 8.0% by 2018, from current levels around 10%, to be broadly in line with the 30-year average CBD vacancy rate. On balance, Macquarie expects effective rents to improve over time but there will not be sufficient upward pressure in the near term. While, nationally, a recovery is expected in Sydney and Melbourne the broker expects Brisbane and Perth office markets will lag, as falling commodity prices flow into business confidence and conditions in these markets.

The A-REITs did outperform the S&P/ASX 200 in November, JP Morgan asserts, the sixth consecutive month of this being the case. The S&P/ASX 200 A-REITs are up 21.6% year to date in absolute terms and 18.1% against the broader market. Large caps which led this outperformance were Westfield Corp ((WFD)), Federation Centres ((FDC)) and Novion Property ((NVN)). Mirvac notably underperformed and was joined in November by Stockland ((SGP)) and Dexus. JP Morgan considers the sector is fairly valued with its top pick being Mirvac, which is trading at a 15% discount to the broker's fair value assessment.

Re-leasing rates will remain significantly negative for the next two years and UBS considers the largest drag will be in office sector. A-REIT rental growth has underperformed versus global peers. The broker suspects this is because rents did not re-base lower as significantly in Australia, as was the case elsewhere after the global financial crisis. In turn, this means upside is more muted. The broker believes little positive organic earnings growth is likely, preferring those A-REITs which have growth options through a global portfolio, such as Westfield, with its US and UK exposure, and Goodman Group, with Japanese developments and Australian residential conversions. UBS flags Sell ratings for Dexus, Novion and Scentre Group ((SGG)) on this basis.

JP Morgan expects believes re-leasing spreads are stabilising, while slow but steady improvement will play out in the better retail centres over the next few years. GPT and Scentre Group are expected to benefit from a more favourable retail sales environment because of their heavy NSW exposure, where retail sales growth is now running at an impressive rate. The broker observes the entry of international retailers into the Australian market is a significant trend over the past few years and the majority of brands have been successful. The ability to attract ad accommodate these stores is likely to create a division in shopping centre profiles and characterise performance over the next decade, in JP Morgan's opinion.

The broker's discussions with the industry signal that H&M and UNIQLO are performing strongly, while Zara continues to trade well. Topshop is softening and GAP is struggling. Forever 21 is the latest entrant in fast fashion and the broker is keen to see how this store progresses, particularly in the larger markets of Sydney and Melbourne. On newly opened store that is expected to have a large impact on A-REITs is Sephora, the French cosmetics and skin care retailer. Sephora plans to open 20 Australian stories, targeting sales of up to $250m within five years.
 

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