Two reits to consider

The Coronavirus hit few sectors harder than retail property. Lockdown measures meant many stores temporarily closed. Others refused to pay rent or demanded cheaper deals.  As the pandemic peaked, the market questioned the industry’s future. More people were expected to buy goods online or avoid shopping centres due to social-distancing rules.  Also, the shopping-centre industry would be mired in years of legal fights with tenants that did not survive the pandemic – and intense renegotiations on lease expiries – it was thought.  Retail property trusts were slaughtered during the sell-off. Vicinity Centres (VCX) fell from a 52-week high of $2.72 to a 91-cent low. Scentre Group (SCG) tumbled from $4.16 to $1.35. Unibail-Rodamco-Westfield (URW) plunged from an $11.74 high to $3.46 as global sharemarkets nosedived.  Charter Hall Retail REIT (CQR) and Shopping Centres Australasia Property Group (SCP) also slid as the market bet on widespread store closures and sharp rental reductions.  Wesfarmers’ news this month that it will close up to 75 small and large format Target stores, and convert others to Kmart stores, compounded the pain for shopping centres. David Jones this month said it will close some of its 48 properties and Myer Holdings looks like it is on life support.  The sector’s worst fears – the closure or shrinking of discount department stores that seemingly chew up acres of shopping-centre space – intensified during COVID-19.  Add to that an Australian economy in recession, the prospect of an economic “cliff” when government wage subsidies end in September, and the risk of a second wave of COVID-19. Who could blame investors for dumping retail trusts first and asking questions later?  

Ongoing threats  

Longer term, COVID-19 has quickened retail trends. Those who bought online for the first time during the pandemic might keep buying more goods that way. Others will become thriftier, spending less on discretionary products and services at shopping centres.  The confluence of these and other trends is best reflected in property valuations. Vicinity this month announced an estimated 11-13% reduction in its asset value, worth up to $2.1 billion.  Conditions were so severe that Vicinity raised $1.2 billion in an equity capital raising at $1.48 a unit to strengthen its balance sheet.  Vicinity’s asset revaluation and emergency capital raising was a defining moment for the sector. If the owner of some of Australia’s greatest “fortress malls” needed to repair its balance sheet, what would happen to lesser-quality shopping centres?  Lower population growth will also weigh on the shopping-centre sector, as will the sudden downturn in international student numbers in Australia.   The market response is telling. Vicinity, Scentre, Unibail and other retail REITs have bounced off their lows during the share market rally but remain a long way off their highs.  The S&P/ASX 200 A-REIT index (which includes all A-REITs) has a negative total return of -17% over one year, despite outperforming this quarter. The ASX 200 index is down almost 6%.   Yet there is more life in select retail property trusts than the market realises – and an opportunity for patient investors with at least a three- to five-year horizon.  

Chart 1: S&P/ASX 200 A-REIT index (XPJ)    

Source: ASX  

Bull case  

Nobody doubts retail landlords face severe economic, e-commerce and legal (rental contract) headwinds. The question is, how much of that is already priced into valuations?  Coronavirus health outcomes are far better than expected. Social-distancing restrictions continue to ease. Shopping-centre landlords report rising foot traffic and store reopenings.  One of my favourite tests of shopping-centre activity is car-parking availability. For the first time in months, it was hard to park at parts of the giant Chadstone Shopping Centre in Melbourne on the weekend.  Granted, my test is hardly scientific. Shopping centres have a lot of hard work ahead, but their recovery looks a lot faster than the market expected when valuations plunged.  Moreover, government wage subsidies, handouts and other concessions may prove a bigger retail tailwind than the market thought, if economic growth recovers.  I read about a boom in sales of expensive shoes as younger consumers cashed in part of their superannuation and rewarded themselves with luxuries. That is terrible for Australia’s retirement-savings regime, but good news for some retailers that are benefitting from consumers accessing up to $10,000 of their superannuation this financial year and next.  Casual workers who effectively got a pay rise from the JobKeeper wage subsidy are another source of demand. None of this, of course, will offset economic recession. But my hunch is retail conditions will not be as bad as the market expects in coming months.  Wesfarmers this week reported strong growth in its Bunnings and Officeworks division as more customers work from home or spend extra time on home improvements.  And GPT Group this week said foot traffic at its regional shopping centres has returned to about 85% per cent of the level a year ago. About 90% of stores at GPT centres are open.   

Solid thematic  

Longer term, I am not convinced consumers will switch en masse to online shopping after COVID-19. Buying clothes and other high-involvement goods in-store is a hard habit to break.  For all the hype, traditional retail in physical stores still accounts for most sales. Yes, online sales are growing quickly and will grow even faster, off a low base. However, predictions that e-commerce will kill shopping centres are premature.  In some ways, COVID-19 could favour fortress malls, at the margin. Cash-strapped consumers might seek more “entertainment” at upmarket shopping malls as they cut back on movie tickets, dining out and other recreation.  Remote working is another opportunity. As more people work in the suburbs rather than in their usual CBD office, fortress malls have an opportunity to develop co-working or other office facilities.  I have long argued that fortress malls can become mini-CBD hubs in the suburbs, and some are doing just that. Converting space previously let by Target, Myer or David Jones into co-working centres that house hundreds of large and small businesses could be the future.  To be clear, retail property trusts face complex challenges. The risk of further valuation downgrades for shopping-centres will weigh on the sector and limit price gains.  GPT’s retail portfolio valuation this month revised down 8.8%. It would not surprise if Vicinity and other shopping-centre owners had further downgrades as asset values fall.  Still, that the market became too bearish on retail property at the bottom and the risks we priced in, in my view. Select retail trusts look moderately undervalued.  

Favoured ideas  

Vicinity (VCX) is my favoured retail property trust at current prices. It owns some of Australia’s best shopping centres, and fortress malls have better prospects given their potential to add a mix of office, residential, hotel and other property types, and more services.  The best fortress malls have high barriers to entry in their market. Imagine the cost and complications of building another Chadstone or Westfield Bondi Junction Shopping Centre in those areas.  Vicinity is well funded after its capital raising and the property valuation downgrade is behind it, at least for now.  Also, Vicinity has relatively less exposure to Target closures or conversions of Kmart stores to Targets, compared to other large property REITs.  Like other shopping centres, Vicinity faces more tenants closing stores or seeking lower rents, and years of complex negotiations. But the quality of its assets should ensure steady demand from other retailers that are able to take on new space.  At $1.74, Vicinity’s price is factoring in a lot of bad news that seems too overdone, given retail announcements this week of rising foot traffic in shopping centres, more store openings and improving demand for some retailers.  Vicinity’s price recovery will take time, but an expected 5% yield next year is an attraction.  

Chart 2: Vicinity Centres    

Source: ASX  

Among other retail property trusts, Charter Hall Retail REIT (CQR) stands out. CQR owns mostly neighbourhood and sub-regional shopping centres and has an expanding portfolio of investments in service stations/convenience stores.  CQR performed solidly before COVID-19 and I like that about half its revenue is from tenants such as Woolworths, Coles, Wesfarmers, Aldi and BP. Woolies and Coles alone account for about a third of CQR tenant composition. Both supermarkets are going gangbusters.  CQR’s portfolio continues to be reweighted towards convenience, non-discretionary retail – a smart strategy in this retail climate. If you believe people will cook at home after COVID-19 rather than eat out, exposure to the supermarket landlords appeals.  CQR fell from a 52-week high of $5.06 to a low of $2.68 during the COVID-19 crisis. The REIT raised $275 million at $2.90 a unit in May, leaving it well capitalised. The current price is $3.60.  

Chart 3: Charter Hall Retail REIT    

Source: ASX  

CQR is expected to yield around 6% next year, on Morningstar numbers. The focus on consumer staples retailers makes CQR more defensive, but also less leveraged to a retail recovery.  Both retail trusts look interesting for investors who want to position for a retail recovery over the next few years. There is still plenty of life left in high-quality retail assets, at the right price.