Bond Yields – A Disruptor to REIT Fundamentals

The sharp rise in bond rates from below 1% at the end of last year to now 1.7% caused a sell-off in yield-sensitive sectors such as REITs.  Consistent with market trends, the steepening yield curve favoured “value” stocks such as Scentre Group (SCG) and Vicinity Group (VCX) over “growth” stocks such as Goodman Group (GMG) and Charter Hall (CHC), despite the divergence in fundamentals witnessed over the reporting season.

Overall, reporting season was a mixed bag with profits boosted by one-off effects, such as in the retail sector with REITs reversing their COVID provisions and benefitting from short-term rental relief. In terms of earnings guidance and upgrades, there was a vast improvement compared to August last year. The majority of REITs provided earnings guidance, with the exceptions being the large retail REITs such as VCX, SCG, and Unibail-Rodamco-Westfield (URW).  A number of REITs provided upgraded FY21 earnings guidance, including GMG raising its FY21 year-on-year guidance by 3% and CHC increasing its FY21 guidance by 4%.

So where to from here? We believe the reopening trade (commencing in November with the announcement of a vaccine) and now the value trade (with the rise in bond yields), have been fully captured and have in fact overshot valuations.  SCG for example, since rebasing its distribution to 14 cps, is now yielding 5% (instead of 8% on FY19 distributions) and is no longer attractive compared to its REIT peers.  GMG and CHC however, which have historically traded at premiums to the market PE, are now trading at discounts.

Despite bond yields having risen sharply over the month, they remain at historically low levels. We believe this is as good as it gets for REITs with cap rate compression doing most of the heavy lifting over the past 5 years.  This is the time REITs should deleverage their balance sheets to drive earnings growth through acquisitions or developments. Both GMG and CHC have the strongest balance sheets in the sector with less than 5% gearing and capacity of >$2.8bn and>$6bn respectively. They both have strong development pipelines with structural tailwinds driving future demand.  For GMG this is reflected in their WIP (work in progress) of $8.4bn, nearly double that of the corresponding period last year, and projected production rate of $5bn per annum, generating strong margins that will support earnings growth over the medium term.  CHC has demonstrated an ability to grow FUM at 30% per annum, has high recurring fees (no performance fees included in the guidance), a diversified portfolio with a long WALE (weighted average lease expiry) of 9.1 years, and is best placed to grow in the alternatives sector and participate in sale & leaseback transactions.

On the flip side, we see continued earnings pressure for large retail REITs: SCG and VCX.  With poor operating matrices (significant negative leasing spread of -12 to -15%, sales MAT (moving annual turnover) of -18%, and low earnings visibility) along with the continued structural shift to online retailing putting pressure on valuations.

On capital management, there is a continued concern on the amount of cap-ex needed to reconfigure assets with David Jones, Target, Myer, Kmart, etc. closing stores over time and the absence of large offshore retailers coming to fill this space. Recently, Myer flagged an additional ~70,000sqm of space reduction in the near-term. Admittedly, VCX has a stronger balance sheet than SCG with gearing at 24% versus 38% (including subordinated notes, which SCG treats as equity). However, in recent years both VCX and SCG’s main developments have been in mixed-use projects such as hotels, residential, and office, which indicates that the return on capital is not there for retail.

Another way to value passive REITs is P/NTA, which reflects the replacement cost in the event of a wind-up. This provides an indication of when a corporate may become more active in share buyback programs or M&A. In this reporting season we witnessed Dexus Group (DXS), GPT Group (GPT), and Growthpoint (GOZ) activating share buybacks with their share price trading at an average 20% discount to NTA. In recent years, transactional evidence has mainly been in office and industrial with offshore demand sustaining sales at or above book for office. Cap rate compression remains strong in industrials and particularly in logistics assets. Retail valuations for large malls seem to have stabilised from the large falls of >10% in August to now -6% for VCX and flat for SCG. With minimal transaction evidence and the structural headwind facing retail, we don’t see support for a recovery in valuations.

On this basis, we see SCG trading on similar discount to NTA with DXS and GPT of around 20% discount a disparity given the higher risk.

For alternative assets such as logistics, childcare, retirement, self-storage, and long WALE assets, these have all realised the greatest cap rate compression and in return NTA appreciation. This is not surprising given the resilience of cash flows as well as capital demand for these sub-sectors.

With our focus on positive free cash flow, strong balance sheet, favourable thematics, and long WALE, we maintain our preference for CHC and GMG (over SCG and VCX), high-quality office such as DXS, and alternative assets, in which the portfolio has a 40%+ exposure, such as childcare (CQE), retirement living (LIC), affordable housing (INA) and data centres (NXT).


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Pengana Capital Group