Originally published by USB Asset Management
We've had numerous client, consultant and company meetings in the past fortnight and the points below provide an insight into the key issues facing the market.
Retail on the nose
This thematic is picking up momentum with another three reports in the past week documenting the headwinds for retail tenants and in turn landlords. We do agree with the general thesis and that's why we went underweight the retail sector last year but where we differ with many is the magnitude of the headwinds. The market assumes Armageddon but forgets that tenants have signed long term rental contracts with landlords and are legally obligated to pay rent. There's been a lot of press about the lack of growth in department stores, discount department stores and supermarkets but the overall sales growth for centres is positive. This is because the vast majority of sales and earnings are derived from mini-majors and speciality tenants; eg JB Hi-Fi Ltd (AX:JBH), Rebel, Cotton On, Just Jeans, Priceline, Smiggle etc. In the larger malls, ~80% of earnings come from these tenants. Retail is constantly evolving and shopping centres are as much about the social exchange as the dollar exchange. We could all watch movies at home but we often go to the local shopping centre to watch it there. It does appear that the market is over-reacting. For instance, Vicinity Centres Re Ltd (AX:VCX), is now trading around its December 2016 NTA of $2.73. VCX owns 50% of Chadstone, one of Australia's best shopping centres and the largest shopping centre in the southern hemisphere (according to Wikipedia). They also own DFO outlets such as Homebush in
Sydney and South Wharf in Melbourne. I'm sure if their major assets were sold on market that they would attract a premium.
Office in the sweet spot
Tenant demand along the east coast is strong and Sydney has seen massive rental growth, up to 30% in some instances in the past year. This is because the State Government has resumed ~20 buildings to build the Metro line. Tenants in those buildings have had to find new accommodation in a short time frame, and new supply is limited. Melbourne is also doing well while Perth and Brisbane appear to have troughed post the mining downturn.
Active vs Passive Management
This debate is once again attracting a lot of coverage. The upshot is that passive funds will continue to be a feature of the market but it will never be the whole market as there are a lot of active managers that offer differentiated product and outperform the benchmark post fees. In the AREIT space, and using the March 2017 Mercer data of ~23 active managers, ~91% of managers (21/23) outperformed the REIT 300 benchmark in the past year, and the average outperformance was 233bps. Over 10 years 14/17 managers beat the benchmark and over 15 years 11/13 managers outperformed. You can slice and dice the statistics many ways but even passive would agree active REIT managers have done a decent job in the past year (post fees). In light of the negative news-flow about the retail sector, passive managers have no option but to own those stocks, while active can obviously be underweight. For what it's worth the UBS fund has outperformed the REIT300 benchmark by 180bps pa (gross) over the past five years, recording an 18.7% return (gross). In the past year it was >400bps above benchmark.
Investa Office Fund (IOF) internalisation
The IOF internalisation vote took another unexpected turn with proxy firm Institutional Shareholder Services (ISS) urging investors to vote against the deal. It is estimated that about 40% of institutional investors rely on that proxy recommendation. When coupled with the vote against by Cromwell Property Group (AX:CMW) who own close to 10%, the vote could be closer than many thought. The proposal needs more than 50% of votes cast to be in favour for IOF to succeed.
What makes it even more interesting is that CMW's largest shareholder is not supportive of the attempted takeover by CMW. The South African based Redefine Properties (RDF), held its 2017 year end update and confirmed it will not fund a bid to acquire IOF. Redefine has two seats on the CMW Board and is its largest holder (~25%). It said it would like to see the CMW/IOF situation resolved, and offered some of its views. The CEO, Andrew Konig, said:
“You have probably read a lot about Cromwell recently. They are involved in a due diligence process with Investa Office fund. Last week there was press coverage saying we were an equity backer. I would like to contextualise that, and say that is not exactly true. We are a supporter of Cromwell, but we are not an equity funder at all in this opportunity. It is way too pricey for our liking.”
Residential defaults
We spoke to one of the apartment developers about their default rates (sales falling over) and they offered the following reasons why defaults have been low and should continue to remain low, with an average ~1%. This includes:
A contract is a binding agreement and developers will pursue purchasers if they default. This has been successfully tested in Australia, and apparently in Malaysia and Japan (albeit not tested in China).
The developer would keep the purchasers 10% deposit if they couldn’t complete. So using price falls of say 15% as an example, Mirvac keeps the deposit and can pursue the original purchaser for the 5% gap.
Most residential markets have appreciated so purchasers are incentivised to settle; ie. they’ve made money.
Developers are now more pro-active in terms of working with lenders to help customers and assist with valuations.
In most cases, the price points are targeted at deepest part of market. Developers with apartments priced at $3m are likely to face higher risks than those around $1m.
Local buyers tend to do almost anything to complete rather than get bad credit ratings.
FIRB buyers do not need to have security to fund the purchase, they just need to pay the 10% deposit and it is the purchasers obligation to sort out finance. The developer said that a FIRB purchase is often associated with a greater good; eg. residency or diversifying capital. Some capital losses could be sustained if they're desperate to get residency. Secondly, most buyers are presently in the money. From our perspective the key default risks are where FIRB buyers are involved and the market falls well below the deposit. This is likely to be tested in the Brisbane and Melbourne apartments in the foreseeable future (my view).
Can the REIT performance continue?
AREITs have been one of the best investments of recent times, delivering 16% pa over 3 and 5 years. This compares to equities at 7% pa over 3 years and 11% over 5 years. AREIT have also performed well vs global markets and global REITs. The key reason why REITs have done well is the global environment that has been characterised by low economic growth and low inflation. This is shown by the local 10 year bond that was 4.5% in Sep-13 and went as low as 1.8% in Sep-16. Because of the uncertain environment with Brexit and Trump, many investors turned to defensive asset classes like bonds, real estate and infrastructure. There's still uncertainty out there which is why REITs have held up well in more recent times.
In terms of the outlook, the starting point is a 5% yield and 3–4% type growth. REITs are in great shape financially having sold a lot of non-core assets such that the overall gearing of the sector is 25%. This means the REITs have options, including buybacks if stock prices fall. That implies there's a floor to REIT stock prices. The key risk is rising bonds, if bonds break 3% there will be selling pressure on REITs as investors switch from defensive to growth assets. At this stage though, there's not much data supporting an improvement in Australia's GDP nor signs of rising inflation. As such it appears bonds will remain around current levels in the next few months.
For those worried about another commercial property crash, two things have caused most downturns. Those factors are too much supply and too much debt. In the Australian market, neither of those issues are of concern.