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Join the queue: REITs face life after coronavirus

Glenn Freeman  |  20 May 2020Text size  Decrease  Increase  |  
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The way we interact with each other and the world at large has changed since the coronavirus pandemic. For one thing, just catching the lift to your office could mean a hours-long wait when city-based businesses re-open in the weeks and months ahead.

Before the strict social distance rule of a 1.5-metre gap between individuals was relaxed on Wednesday afternoon—after pressure from various industry groups including the Property Council—the maximum occupancy of a 21-person elevator would have been just four people. For a 17-person lift it would be two, and just one for smaller elevators that would normally hold 13 people.

But Safe Work Australia is still encouraging elevator programing alterations and staggered start times for office workers, to minimise crowding.

And there's also the issue of floor-space for employees. In the longer-term, buildings may be designed to accommodate fewer people in the same size footprint, with larger elevators to provide more personal space.

These are among the many challenges office building landlords have been forced to consider in preparing for the new normal of running a business post-COVID.

Dexus, one of the largest owners of office buildings, which comprise around 65 per cent of the company’s total earnings, has acknowledged this in its latest quarterly shareholder update.

Management referred to a reduced focus on workplace density as a potential benefit in the aftermath of COVID-19.

But Morningstar equity analyst Alex Prineas doesn’t expect companies will pay up for more space.

"What will drive rents is the value that a business places on an office," he says.
"So, if they're able to fit fewer employees in, then they're not going to be putting as much value on that, and aren't going to be willing to pay."

But Prineas has long viewed office rents as overheated, particularly in Australia's east coast capitals. He previously expected an oversupply of office space would "end the party" as growth outpaced employment growth.

"COVID-19 has brought the slowdown forward and we revise down our expectations for fiscal 2020 and 2021," he says.

Australian real estate investment trusts (A-REITs) are often referred to as bond proxies because they respond markedly to changes in interest rates. This is because loan repayments are usually the largest business expense for companies, and low rates reduce the expense of servicing that debt.

All else being equal, this can lead to an increase in profits and greater demand for shares, which tends to push share prices higher.

'Low rates isn't an investment thesis'

But Prineas disagrees.

"Low interest rates are not a good investment thesis for an asset class," he says.

"They're not bonds, so if their earnings come under threat, then share prices will get hammered.

"And retail proves that: you've got a sector where earnings have come under pressure and stocks didn't perform very well."

Over the first three months of 2020, share prices of large mall owners Unibail-Rodamco-Westfield (ASX: URW), Scentre Group (ASX: SCG) and Vicinity Centres (ASX: VCX) fell by an average of 50 per cent. Though they've recovered slightly in April, their returns are still deep in the red.

COVID hits Australian mall owners

Malls

Source: Morningstar Premium

"We were saying 'be careful of office and industrial' for that reason," Prineas says.

"They were priced for perfection on this interest rate theme, and any threat that comes through is going to see them hurt."

Estimates on REITs slammed

Morningstar's fair value estimates on retail REITs have been slashed because of this view, and Prineas points to three key reasons:

  1. They've lost earnings during the lockdowns
  2. There are flow-on economic effects
  3. The acceleration of a structural shift toward e-commerce.

his last point is also emphasised by Morningstar retail sector specialist and equity research director Johannes Faul. He estimates that the pandemic has pulled forward online shopping's encroachment on bricks-and-mortar retail channels by around five years.

But Prineas remains upbeat on the longer-term outlook for retail REITs.

"Eventually the lockdown ends and economic effects recover. And there's still only a certain number of ways that you can get the eyeballs of consumers, and locating a store in a high-quality mall is one of the few ways to do that."

Finding attractive REITs

To find the most appealing listed property stocks, investors need to look beyond the current share price versus Morningstar's fair value estimate.

The debt levels on company balance sheets have become crucial in recent months.
In addition to looking at the net debt-to-equity valuation Morningstar analysts attach to companies, the Fair Value Uncertainty rating is key.

The higher debt risk saw Unibail-Rodamco-Westfield and Scentre Group's Uncertainty ratings lifted from Medium to Very High in March, and from Medium to High for Vicinity.

Some of the standouts in the category, with appealing valuations and Uncertainty ratings of either Low or Medium are Charter Hall Group, Charter Hall Social Infrastructure, Arena REIT and GPT Group.

Charter Hall Group (ASX: CHC)

Analyst Rating:  4-star | Uncertainty Rating: Medium | Price-to-Fair Value: 0.92

Charter Hall is a property fund manager and developer with assets primarily in Australia.

Morningstar senior equity analyst Gareth James last month upgraded his 2020 Fair Value Estimate by 3 per cent for the narrow-moat company.

This is largely because the negative effect of COVID-19 on the group's commercial property holdings—which he expects will be hurting for the next three years—will be offset by its funds management arm.

"We believe Charter Hall’s balance sheet and well-oiled funds management machine places it in a strong position to pick and choose attractive deals, which should add value for long-term shareholders," James says.

Having closed at $8.35 on Wednesday afternoon, Charter Hall is currently trading at an 8 per cent discount Morningstar's $9.10 fair value estimate.

James also highlights the appeal of the childcare sector within the listed property space.

"We're still going to need the same number or more child care centres in five or 10 years’ time, but you probably couldn't say the same thing about bricks-and-mortar retail stores," he says.

The speed with which the federal government stepped in to temporarily lift the childcare subsidy to 100 per cent to shore up the sector is a key example of this.

Though it remains uncertain how long the free childcare scheme will remain in place—a report released yesterday suggests it will likely end by 28 June—there are suggestions it could be extended.

"COVID-19 is a unique situation, but aside from demand increasing over long-term, there's also the notion that it's a pseudo-government sector," James says.

"The government isn't going to walk away and let the sector collapse. If it appears ending it now will cause a problem for the sector, then I think they will change it longer-term."

Charter Hall Social Infrastructure REIT (ASX: CQE)

Analyst Rating:  5-star | Uncertainty Rating: Medium | Price-to-Fair Value: 0.65

CQE is the largest childcare centre-focused REIT in Australia and holds a portfolio of more than 400 childcare centres in Australia and New Zealand.

James highlights several attractive qualities, including:

  • high occupancy rates
  • high tenant renewal rates,
  • relatively long weighted average lease expiry of more than 11 years.

"The childcare sector was profoundly rocked by coronavirus-related restrictions in Australia, which caused a significant fall in childcare centre attendance in March 2020," James says.

Given the quite high fixed costs of childcare centres, the crash in attendance numbers and revenue threatened industrywide losses, redundancies, and ultimately bankruptcies.

"But as we expected, the federal government was not prepared to allow such an economically important sector to collapse," James says.

ARENA REIT (ASX: ARF)

Analyst Rating:  4-star | Uncertainty Rating: Medium | Price-to-Fair Value: 0.76

This holds a similar portfolio of childcare assets to Charter Hall Social Infrastructure REIT, while currently trading at slightly higher levels.

James says ARENA is well within the minimum capital requirements of its debtors, with a maximum loan-to-value ratio of 50 per cent, and doesn’t expect covenants to be breached

"We expect Arena and Charter Hall to benefit from their relatively strong portfolios, which are exposed to relatively high-quality centres and tenants," James says.

"In many cases, rental income is protected by cross guarantees and the backing of large operators such as Goodstart Early Learning and G8 Education, Australia's largest and second-largest childcare operators."

GPT Group (ASX: GPT)

Analyst Rating:  4-star | Uncertainty Rating: Medium | Price-to-Fair Value: 0.84

A diversified property company, GPT's portfolio spans the retail, office and industrial segments which comprise around three-quarters of its revenue. The remaining 20 per cent comes from funds management.

Morningstar's Prineas recently trimmed his fair value estimate for GPT by 9 per cent to $4.90—largely in response to coronavirus's impact on the retail sector.

"One quarter of GPT’s retail income is up for expiry or market review in 2020. GPT is also exposed to department stores, for example its Highpoint centre in Victoria hosts Myer, DJs, Target and Big W," he says.

Prineas also expects contracted retail rents and new rents to dip by 15 to 20 per cent in calendar 2020.

But the company continues to trade around 16 per cent below these levels, closing at $4.11 on Wednesday afternoon.

"We expect office will take a hit … but we already thought the office segment was overheated and factored in a downward mean reversion in rents before we heard of COVID-19," he says.

But on the bright side, the downturn is delaying new supply in the office space, which may benefit GPT by hurting its competitors.

"Because it has one of the strongest balance sheets in the sector and several large projects near shovel-ready."

Prem Icon Premium subscribers can create a list of all the REITs in Morningstar's research stable along with their Morningstar Analyst Ratings, Fair Value Estimates and other information.

 

is senior editor for Morningstar Australia

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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