HomeCo Daily Needs REIT’s (ASX: HDN) 2024 half-year result aligned with our expectations. It posted funds from operations of 4.3 cents per security, halfway to our full-year FFO estimate of 8.6 cents, which aligns with unchanged management guidance. We maintain our fair value estimate of $1.45 per security, and no-moat HomeCo Daily Needs screens as undervalued.

We’re encouraged by 6.4% leasing spreads, the difference between rents on expiring and new leases at the same site. This was superior to the already good 6% spreads in fiscal 2023, and offers reassurance that HomeCo Daily Needs can increase revenue from its rents that are far below listed peers.

About 50% of fiscal 2024 expiries have been addressed, adding comfort that the REIT is not too exposed to the risk of a retail slowdown. About 25% of the REIT’s tenants are names we view as unlikely to miss a rent payment. Some rivals earn about half their rent from supermarket majors such as Coles and Woolworths, whereas those two names only make up 10.6% of HomeCo Daily Needs’ rent.

It continues to increase rents and exposure to large anchor tenants by moving toward its target of 50% in neighborhood retail, 30% large-format, and 20% in health and services, with progress achieved via tenant remixing, acquisitions and disposals, and redevelopments.

The REIT disposed of $302 million of large-format retail sites at an average capitalization rate of 5.4%. It also acquired $165 million in assets at the same cap rate, and we agree with management’s assessment that the acquired assets have superior growth potential to those sold. Management highlighted the Leppington neighborhood center, a relatively new development by Woolworths that opened in August 2023, with advantages including proximity to the rail station and undeveloped land on the parcel that could be redeveloped as population growth provides infill demand.

Business strategy and outlook

HomeCo Daily Needs REIT is underweight its target 50% neighborhood malls, and 20% health and services, and overweight the target 30% large-format. We expect neighborhood mall and health exposure to increase toward the target, via acquisition, development and tenant remixing, as population growth in HomeCo’s catchments makes neighborhood malls more feasible. The REIT faces cyclical risks in the event of a recession, but should achieve good long-term rental growth as its large-format sites mature, and it grows exposure to neighborhood tenants.

Before developments commence, management seeks: tenant commitments for half the project, fixed price development and construction contracts, and planning approvals for the entire project. HomeCo commenced circa $80 million of developments in fiscal 2023, and expects another $120 million in fiscal 2024, which we view as reasonable based on the group’s sites, and strong population growth at present. HomeCo has circa $4.6 billion of assets at June 2023, so fiscal 2023 and 2024 estimated development spend totals about 5% of the asset base, which is digestible.

Management has identified development opportunities totaling $600 million, or about 15% of the asset base—financially achievable if done gradually.

The REIT could also rebalance via acquisitions. The REIT's 2020 launch was off the back of acquiring former Masters sites, a savvy move. HomeCo merged with Aventus Retail REIT in 2022. Aventus had a larger portfolio and a higher weighting to large-format tenants and less in neighborhood retail. We wouldn’t be surprised to see similar opportunistic deals in future.

HomeCo has been acquisitive, using debt, cash flow from existing properties, and issuing new equity across a range of deals. Acquisitions in late 2020 were debt-funded, which made sense given low interest rates on offer amid the pandemic. It made several equity-funded purchases in 2021, taking advantage of HomeCo’s stronger equity markets, issuing equity at $1.30, 1.45, and 1.61, all above the current security price. Disposals outweighed acquisitions in the first half of fiscal 2024, which we view as prudent given elevated debt and inflation risks.

Risk and uncertainty

Learn more about how to think about business risk as an investor.

HomeCo Daily Needs REIT’s Morningstar Uncertainty Rating is Medium. Near-term uncertainty comes from the REIT’s substantial exposure to large-format retail, which faces cyclical challenges if retail slows down, with high interest rates weighing on consumer spending, particularly large ticket-price consumer durable items typically sold in large-format retail locations. The format also depends on household formation, which could be constrained by housing construction bottlenecks.

Despite these cyclical headwinds, we think earnings are reasonably predictable over the next five years due to the REIT’s leases to a solid list of tenants. Longer term, Australia’s economy should be underpinned by population growth, and current housing construction bottlenecks are likely to ameliorate.

Structural change from online shopping and price comparison is a longer-term threat, although we expect population growth, redevelopment, and remixing of tenants to increase the REIT’s exposure to the more resilient neighborhood retail category. The target as a percentage of assets is 50% but we wouldn’t be surprised to see it go higher in the long run.

In light of the moderate financial quantum of developments versus the REIT’s asset base, and the fact that HomeCo’s retail sites are not complex, we think development risk is moderate for HomeCo though the REIT may have to curtail development plans if interest rates get to onerous levels.