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In most markets, rising bond yields would negatively impact property trusts (also known as AREITs or Australian real estate investment trusts).
As interest rates rise, AREITs less attractive compared to other income assets, so they tend to underperform. And as many are geared it means that when the cost of borrowing goes up, distributions to unit holders could fall in the medium term.
But in 2018, the listed property trust sector has done pretty well. In fact, it has outperformed the broader market (taking into account dividends and distributions). In the calendar year to 19 October 2018, it had returned 2.23%, compared to the S&P/ASX 200’s return of 1.32%. A small outperformance, but an important outperformance.
What’s driving this outperformance? Firstly, it is not one homogeneous market. There are office, retail, industrial, residential, specialised (eg. data centres) and diversified AREITs. The standout performers have been in the commercial office and industrial areas.
Let’s focus on the commercial office sector, where the drivers have principally been low vacancy rates and increasing rents, limited near term supply, and corporate activity.
While demand for floor space has increased moderately through urbanisation and employment growth, supply has been constrained. The “residentialisation” of CBDs has led to the conversion of older office buildings to apartments and reduced available supply. Flexible working and “hot desking” have not had the impact that developers feared, and much needed infrastructure projects have, in some cases, further reduced supply (for example, the building of the light rail and new underground rail stations in Sydney).
This has led to a fall in vacancy rates and driven up rents, particularly on the eastern sea-board. According to Dexus, the prime average vacancy rate for the Sydney CBD was 5.2% as at 30 June 18, and is forecast to fall to 3.5% in FY19, before rising to 4.6% in FY21 and remain below the long-term average of 7.9%. Effective rental growth in the Sydney CBD in FY18 was 12.5%.
Frank Gelber, from BIS Oxford Economics, is bullish about the Sydney and Melbourne office markets. Speaking on Switzer Radio the other week he said that Sydney was “supply constrained” and that it could look forward to “three years of vacancy rates of about 3%”. He said that this would “drive up rents and property values by about 40% to 50%.”
While vacancy rates in Brisbane, Adelaide and Perth are expected to fall over the medium term, Frank cautions that he is not bullish on these markets (see the BIS Oxford Economics ‘Stage of Cycle’ graph below).
For investors, accessing the commercial property market is usually done through a multi-property listed AREIT. There are also unlisted trusts that are typically established to fund the purchase of a single commercial property, but they are close ended and access is restricted once established.
Here is a run-down on three commercial office trusts. A fourth, the Investa Office Fund (IOF), is the subject of a takeover bid from Oxford Properties (which is owned by a Canadian pension fund). The offer of $5.60 per unit has received a unanimous recommendation from the Investa Board. A fifth, the small Australian Unity Office Fund (AOF), received an unsolicited takeover bid from Starwood on 8 October.
With a market value of around $10.5 billion, Dexus is the biggest of the “pure-play” office funds. Strictly speaking, Dexus is not “pure-play” because it has a funds management business, while others that are classified as ‘diversified’, such as the GPT Group, are pretty big in office as well. But for all intents and purposes, Dexus meets the bill.
Dexus has a property portfolio of $13.3 billion. Of this, $11 billion is office, through 46 properties, and $2 billion is industrial. 70% of the office portfolio is based in Sydney, with 59% in the CBD or city fringe area. The portfolio is 96% leased, with a WALE (weighted average lease expiry) of 4.6 years.
Dexus also manages properties for other clients. The funds management business looks after $13.9 billion of properties for 73 clients from seven geographies. A third division, trading, makes a small contribution from development.
The REIT has gross debt of $3.3 billion, which on a ‘look-through” basis, gives it a gearing ratio of 24.1%.
Like most property trusts, Dexus distributes to security holders 100% of the adjusted funds from operations, which is after finance costs and building capex. For Dexus, the property portfolio contributes about 80% of this and funds management about 15%.
In FY18, Dexus distributed 47.8c per unit, up 5.1% on FY17. At the time of writing, this puts it on a historic yield of 4.78% (net franking about 10%). It has guided to growth in the distribution of “circa 5%” for FY19.
With regard to the brokers, the consensus target price is $10.58, 3.7% higher than the current market price. According to FN Arena, of the six major brokers that cover the stock, there are three buy, two neutral and one sell recommendation.
Cromwell is not your typical A-REIT. In fact, the Group describes itself as a “real estate investor and manager operating on three continents with a global investor base”.
That all said, it is not that dissimilar from Dexus, in that it is both a property owner and a funds manager. Where it is different is that the funds management business extends internationally, and it is a lot smaller with a market cap of just over $2 billion.
Its property portfolio consists of 23 assets with a value of $2.5 billion. It focuses on secondary assets in the CBD, CBD fringe and established suburban markets that it thinks have the potential to outperform.
It runs three portfolios – a Core Portfolio of long WALE, full occupancy buildings requiring little CAPEX (buildings here include QANTAS’s head office buildings in Mascot and Soward Way in Canberra which is leased to the Federal Government); a “Core + Portfolio” of buildings with medium term WALE and leasing upside; and an Active Portfolio of vacant or near vacant buildings that it is looking to reposition. The Core is about 58% of the portfolio and Core + is 36%, meaning the overall portfolio has a WALE of 7.4 years and is 94.5% leased. By income, NSW properties make up 51.5%, with ACT at 18.9%.
The property portfolio accounts for almost 75% of operating profit. The other 25% comes from the funds management segment, which consists of $6.7 billion of wholesale funds and $2 billion of retail funds. The latter includes some unlisted funds, such as the Cromwell Direct Property Fund. Last year, the Group launched a €303m European property fund on the Singapore Stock Exchange (CEREIT).
On a look through basis, gearing is at 43%. Cromwell says that this “is at the bottom of the target range for this point in the cycle”.
Cromwell has guided to a distribution for FY19 of “no less than 7.25 cents per unit”, approximately 90% of operating earnings. At a unit price of $1.02, this puts it on a prospective yield of 7.11%.
Of the three major stockbroking companies that cover the stock, there is one neutral recommendation and two sell recommendations. The consensus target price is, $1.05.
3. Centuria Metropolitan REIT (CMA)
Centuria Metropolitan (CMA:ASX) is a “pure-play” office REIT. It has recently completed the acquisition of four buildings worth $520 million, which will take its property portfolio to $1.5 billion.
Centuria’s strategy is to acquire and operate “fit for purpose” commercial office buildings in the major metropolitan markets. These are in the capital cities, but not prime CBD, and include areas such as Chatswood in Sydney or Richmond in Melbourne. Typically, rents are higher in metropolitan markets.
Post-acquisition, the portfolio will comprise 23 buildings which are 98.8% occupied with a WALE of 4.2 years. 84% of the portfolio is on the east coast, with NSW contributing 24%, Queensland 36% and Victoria 24%.
Gearing is at 36.6%, but Centuria intends to divest two non-core assets to get back to its target range of 25% to 35%.
Centuria has guided to a distribution of 17.6 cents per unit in FY19. At a price of $2.41, this puts it on a prospective yield of 7.30%.
Only two of the major brokers follow Centuria, with both having buy recommendations. UBS has a target price of $2.58, while Morgans has a target price of $2.52. The consensus of $2.55 is a 5.8% premium to the last price of $2.41.
Existing Centuria holders have until 5.00pm on Monday 29 October to decide whether to take up their 1:3 entitlement at $2.43 per unit.