Brokers Probing For Growth Among A-REITs
FY18 guidance among Australian Real Estate Investment Trusts (A-REITs) is mixed although, generally, the pace of growth has slowed. With a relatively low FY17 start point of 2.0%, Macquarie observes A-REITs have not had a growth rate this low since FY12. Nevertheless, the broker is encouraged by the early performances in FY18, as the sector appears much more resilient than the broader market.
Goldman Sachs expects better outcomes in the active A-REITs, in particular Mirvac ((MGR)), Stockland ((SGP)), Goodman Group ((GMG)) and Propertylink ((PLG)). Among passive A-REITs earnings are more subdued, as Charter Hall Retail ((CQR)), Vicinity Centres ((VCX)) and Hotel Property Investments ((HPI)) guided to minimal or no growth.
Mirvac and Charter Hall ((CHC)) stand out for UBS, with 11% and 18% growth respectively in FY17. The broker also finds Westfield ((WFD)) a value US-dollar play. UBS least prefers expensive stocks such as Dexus Property ((DXS)), Investa Office ((IOF)) and Goodman Group.
The broker suspects the former two may disappoint in terms of cash flow, while Goodman's earnings quality has deteriorated, despite strong tailwinds in the logistics sector.
Shaw and Partners notes the average sector pay-out ratio in FY18 is forecast around 82.1%, slightly lower than the 82.9% in FY17. The broker attributes this to large retails like Vicinity Centres and Scentre Group ((SCG)) cutting ratios in order to more closely align distributions with adjusted funds from operations.
Macquarie also points out that attention has sharpened on free cash flow, and that 10 passive A-REITs still pay in excess of this in FY18. The broker is disappointed with Westfield and Scentre Group. Nevertheless, with sector gearing at around 24% and passive names at around 30% most balance sheets remain in check.
The season shone the light on those that are growing earnings and Macquarie remains overweight on the growth vehicles such as Goodman, Mirvac, Lend Lease ((LLC)) and Charter Hall.
UBS believes GPT ((GPT)) and Mirvac are best placed in the office market. Goldman Sachs agrees Mirvac is attractive versus peers because of its leverage to outperforming urban locations, and a largely pre-sold commercial and residential development pipeline, but suggests GPT faces the strongest headwinds in a rising interest rate environment, given below-sector earnings growth expectations and a full valuation. The broker finds Propertylink attractive from a yield-plus-growth perspective.
Goldman Sachs suspects that near-term lease expiries limit landlords' ability to capture rental uplift in the tight Sydney and Melbourne markets. Ord Minnett is disappointed with the earnings outlook in the office sector, as guidance from Dexus forecasts 2-2.5% growth and Investa Office just 1%, while Cromwell Property ((CMW)) expects a fall of -4.5%.
Office markets continue to diverge by city. Brisbane and Perth are undergoing a sharp cyclical correction and Macquarie expects this to remain the case for the next few years. Solid demand, on the contrary, is continuing in Sydney and Melbourne.
Effective rents also support this diverging market theme as Sydney and Melbourne have recorded a positive movement of 14.2% and 5.5% in prime CBD, respectively. Perth rents suffered the most over FY17, down -13.1% for prime CBD.
Scentre Group, Westfield, Vicinity Centres and Charter Hall Retail have been caught up in the slowdown and threat of Amazon, Macquarie observes. Income was fairly resilient although sales slowed. Development returns remain subdued and this is expected to continue.
Macquarie believes a decline in returns is likely to result from higher incentives, lower rents from international retailers and a high proportion of expenditure allocated to non-rent producing refurbishment.
Goldman Sachs suggests that valuers are beginning to factor in lower rental growth and increased capital expenditure. While occupancy levels have been maintained, sales and leasing outcomes are more mixed, the broker adds. Charter Hall Retail and Scentre Group fail to excite Ord Minnett, which notes the environment is challenging, although cash flow is positive.
Yet, UBS flags Scentre Group as an opportunity among retails, as operating metrics are outperforming peers despite the scepticism in the market. The broker is less positive on GPT in this regard as earnings quality is low despite strong headline growth.
Residential conditions have begun to moderate because of an increasing cost of credit and lower availability. Macquarie expects regulatory pressures will moderate the residential cycle, as volume growth is already lower versus a year ago and dwelling prices have decelerated in recent months.
Despite a relatively negative outlook, the broker notes the residential developers continue to outperform, as elevated margins are realised from better-than-expected dwelling price growth and demand over the last few years.
Settlement volumes were at a record high for all three listed developers under coverage (Lend Lease, Stockland and Mirvac). Macquarie expects defaults to remain low as motivation to settle is strong in most markets, given significant dwelling price growth relative to when product was pre-sold.
There is also enhanced motivation for foreign investors to settle, with a decline in the Australian dollar versus the US since initial pre-sales, despite the currency running higher in the last few months. Alternative financing markets are increasingly available for foreign investors too, in the face of the withdrawal by domestic banks.
Residential development profits may be at cyclical highs but Macquarie is still cautious about the extent these businesses are able to continue growing, and the sustainability of profits remains a key point of contention across the market in valuing these businesses.
Ord Minnett agrees residential results stood out in the face of a tightening credit market. Developers are getting through apartment settlements as expected, with minimal defaults, and rising land prices are supplementing margins in the case of Stockland, Mirvac and Lend Lease.
Brokers observe elevated demand from both domestic and foreign capital for the relatively attractive yields in this asset class. Improved transport and warehousing business conditions are contributing, with e-commerce a key driver.
Macquarie notes initial yields remain healthy for Goodman, the only pure industrial A-REIT under its coverage. Charter Hall's portfolio stands out for Goldman Sachs in terms of the weighted average lease expiry and vacancies.
Commentary around buy-backs has been prevalent, although Goldman Sachs notes Vicinity Centres and Charter Hall Retail are the only A-REITs under coverage that are active in the market, which is considered prudent given their discounts to net tangible assets (NTA).
The broker believes buy-backs represent the highest risk-adjusted return on capital given equity market pricing versus NTA and direct market yields that are at, or below, listed A-REITs yields. Nevertheless, the broker points out that history shows A-REITs typically do not act on their buy-back programs.
Macquarie observes, in terms of capital deployment, there have been limited growth opportunities. Hence, buy-backs have been a key deployment method, in view of where share prices are trading relative to NTA, and this should act as a stabilising factor for the sector. Given current spreads between earnings yields and cost of debt, buy-backs should generally be accretive to earnings.
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