Alexander Prineas
Australian listed property trusts trade at substantial discounts to net tangible assets (NTA). The magnitude of the discounts implies a looming commercial property correction, or even a crash.
At the time of writing, diversified landlord and residential developer Mirvac (MGR) trades at a 24% discount to its 31 December 2021 NTA, and a 32% discount to our $3.10 fair value estimate. Dexus (DXS) trades at a discount of 21% to NTA and 14% versus our fair value estimate. Many REITs trade on similar discounts, noting some own intangible assets that are not included in the NTA calculation, but are valuable. For example, narrow-moat DXS has a funds management business, and no-moat MGR has a residential development business, the latter we believe is worth circa 50 cents per security.
During the COVID-19 lockdowns, a key risk for REITs was debt covenants linked to earnings. These include interest cover requirements, which means a REIT’s earnings need to exceed interest payments, typically by at least 1.5–2.0 times. With REITs unable to collect rent from locked-down tenants, this was a risk.
Earnings are recovering, but there is now the risk of covenants linked to asset prices being breached. These covenants typically include constraints such as limits on debt/asset ratios. If commercial property asset values fall as rates rise, overindebted REITs could be forced to sell assets or raise equity in weak markets.
Despite this, we have maintained our fair value estimates for REITs under our coverage. We had already factored in higher debt costs, typically assuming a long-term cost of debt of roughly 6%, varying slightly by name. Apart from a few highly leveraged names with gearing above 40%, such as Cromwell (CMW) and Unibail-Rodamco-Westfield (URW), Australian-listed REITs under our coverage have balance sheet gearing (net debt/assets) below 35% as at 31 December 2021. Furthermore, our intrinsic valuations are typically already below respective NTAs.
Reassuringly, some REITs have announced preliminary valuations for 30 June 2022, showing physical asset values were holding up so far, despite higher interest rates.
Mall operator Vicinity Centres’ (VCX) preliminary revaluations indicated a 1.7% uplift in book values over the half year to 30 June. A strong recovery in retail conditions contributed to capitalisation rates, essentially a yield number, used to value commercial property, tightening from 5.35% to 5.31%. CEO Grant Kelly said income growth was a predominant driver of the uplift, and the guidance update “largely reflects the sustained strength of retail sales and improved negotiation outcomes with retailers, and therefore stronger than expected cash collections in respect to current and prior years.” VCX also upgraded its earnings guidance, now telegraphing funds from operations (FFO) of at least 12.6 cents per security, up from its previously stated range of 11.8 to 12.6 cents.
Neighbourhood mall operator Shopping Centres Australasia (SCP) also revalued its property portfolio in June, revealing a 1.4% valuation uplift. Despite higher interest rates over the course of the year, SCP noted its cap-rates tightened from 5.45% to 5.43%. It also recently purchased some neighbourhood malls at a 24% premium to the book value of the vendor, Centuria Capital Group.
Office REIT DXS also revealed updated valuations, seeing its book values climb 2.2% over the six months to 30 June.
Admittedly, we take these valuations with a grain of salt, noting there have been few commercial property transactions in the recent quarter on which to cross-check the NTAs. Activity has ground to a halt, with buyers seemingly holding out for better prices, and sellers anchored to high prices seen in transactions earlier in the year. The result is a standoff, and our expectation is that buyers will eventually benefit from lower prices.
We continue to monitor the risks and remain watchful for any evidence of a possible disorderly unwind. Even so, this uncertainty appears to remain far from the market’s fears of rapidly widening cap-rates implied in the current security prices, which would be needed to crash commercial property. The fact 30 June valuations have held up seemingly gives REITs another six months in which to get their affairs in order should tougher conditions eventuate. We expect some cap-rate widening and ensuing pressure on NTAs, but we expect this to be partly offset by further leasing progress on vacant assets, and construction progress for development projects underway. While it varies by name, the recent correction has pushed many names in the REIT sector into fairly valued or undervalued territory.
MMM some good points above. In saying that I would prefer GMG over most other Reits as they seem well managed. My thought are that GMG is well positioned when it comes to the oline market gaining share on retails sale which is meant to expand in the long run considerably.
In saying that, we are also experiencing a shortage of supply in most areas relating to imports from China etc. My wife owns a Homewares store and cant get many items at the moment with no dates provided on arrival times. She has also noted other Homeware stores all selling the same items that usually have points of difference in there stocked items, again this tell us there is only whats in the country for stores to stock. This could mean that Industral storage may not be needed as much as they cant get stock to fill them, or maybe they need more storage so they can maintain stock levels to keep business turning over. We saw Kogan do this recently and ended up with to much stock and increased costs due to extra storage.
Still I see industrial warehouse storage (Goodman) as the better one over office space Reits . Aslo Stay away from Retail. Scentre Group (Westfield) looks quiet compared to what it used to be. Late night (Thursday) shopping is really quiet. I know a Manager of a Country Road store that said there takings are way down across the state (Foot traffic in Westfield and other centres most noticably) I think peoples habits have changed with regards for the need to spend. Two years of Covid broke some well intrenched habits. Makes a case for online spending right.
I think Peregrine detailed the risk calculation that needs to be taken with REITs in a rising interest rate environment. Cap rates just cannot be maintained at these levels.
I only hold two. Goodman and CIP: centuria industrial.
The reason is the ever increasing move to online commerce. A bit like the move to the cloud 5 years ago, this is a worldwide juggernaut that has a long way to go in most of the world (outside of the US). Goodman gives you exposure to really smart development (and management) of complex inner city delivery/logistics centres. The have a bit of a moat in terms of proven execution of these kinds of facilities.
centuria offers one of the few pure play industrial REITs in Australia. I am not confident of what will happen in shopping centres and offices over the next 10 years and want to avoid them.
lastly, it is worth looking at the WALE and how long lease contracts are structured with respect to inflation linked increases. If inflation picks up domestically and you have a long lease that can only be increased by3% pa Is actually a negative: you can’t pass costs along to the tenant. Shorter leases which are usually viewed as a negative, allow any new contract to be renegotiated favourably to reflect inflationary pressures.
Apart from the energy space, not many things get me less enthused than the REIT sector on the ASX. Having said that both Goodman Group and Charter Hall (CHC) are starting to look interesting to me. They’ve become more property fund managers and developers in recent years in particular than traditional REITs with their fund manager divisions growing at a pretty rapid rate. They’re both companies who have had a truely tremendous track record over the last 10-15 years and almost always seem to beat expectations and upgrade guidance done reporting reason. Goodman has more exposure to industrial property and Charter Hall more office property. Do people have a view on these going forward in a rising interest rate environment? I wonder whether the best times are over or because they’re so well managed they’ll continue to get the job done.
Disc: Recently added CHC to strawman portfolio