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Australian commercial property fears overdone, analysts say
Falls in commercial property prices fuelled by higher interest rates and a looming economic recession could force office vacancies higher, but downside risks are largely priced into Australian real estate investment trusts (REITs), many of which are trading at discounts to their valuations, according to new research from Morningstar.
After a selloff in property trusts during March as interest rates rose and recession fears gathered momentum, Morningstar equity analyst Alexander Prineas (pictured) said he sees value in some good-quality REITs, including Charter Hall Group, Dexus, GPT Group and Mirvac.
While REITs have been touted as risk investments, with the recent shift toward hybrid work undermining occupancy levels and the collapse of banks in Europe and the US renewing fears of global recession, Prineas sees positives beyond that, noting that major Australian REITs have solid fundamentals.
At the end of 2022, Charter Hall had a modest office vacancy rate of 2.6 per cent; for Dexus, GPT and Mirvac vacancies were at 4.7 per cent, 12.1 per cent and 3.7 per cent, respectively, and the REITs have manageable gearing levels ranging from 25-32 per cent. “With long-term debt locked in, we don’t think these stocks need to tap debt markets until 2025 or later,” Prineas said.
“Charter Hall’s gearing on its balance sheet is a miniscule 3 per cent,” he said. “Look-through gearing is higher at 32 per cent; however, this is partly offset by committed equity lines from fund management investors that Charter Hall can call on.”
He noted that lenders to Charter Hall funds have no recourse to the assets of Charter Hall Group, so if one of its individual property funds gets into trouble, Charter Hall’s financial exposure would be limited to its investment in the fund.
For the other major office REITs, Prineas said, “their income looks reasonably well underpinned by long leases to strong tenants.” The average lease length for Charter Hall, Dexus, GPT, and Mirvac was 7.7, 4.6, 4.9, and 6 years, respectively, at the end of 2022.
“By contrast, troubled overseas portfolios had fundamentals that were worse, and deteriorating. Defaults from Brookfield office assets in Los Angeles reportedly had vacancies as high as 27 per cent, worsening from 20 per cent over a three-month period.”
Some concerned about debt levels
Research from UBS also notes that the Australian REIT sector is trading at around a 10 per cent discount to UBS price targets. However, in an extended period of macroeconomic uncertainty and lingering fears over how far interest rates will climb, UBS favours REITs with lower debt over those with high levels.
For example, the investment bank prefers Goodman Group over Charter Hall, saying it is one of the best-positioned REITs to absorb the shock of higher interest rates. UBS has a buy call on Goodman and a price target of $23; the stock was trading at $19.50 as of April 5.
Key drivers of the business largely improved over December 2022 quarter, including high occupancy for Goodman’s industrial and office properties and strong development margins, according to UBS.
In contrast, the bank has a sell rating on Charter Hall and notes that retail inflows are expected to slow into its managed funds as risk appetite reduces.
UBS is also concerned about Charter Hall’s cost of debt, which rose to 3.8 per cent in the first half of 2022-2023, up from 3.1 per cent from the previous year. With a gearing level of greater than 30 per cent, this cost could keep rising given higher interest rates.
UBS also prefers GPT, one of Australia’s largest diversified listed property groups, over Dexus and says its retail and logistics properties and funds management division are performing above expectations. However, GPT’s price has been weighed down by recession fears and concerns about rising office vacancies. UBS has a $5.13 price target on GPT compared with its current market price of around $4.30.
Global REIT returns show resilience
According to Mark Mazzarella, portfolio manager with Dexus, the speed and severity of last year’s drop in REIT prices was largely a result of increasing interest rates, which negatively impacted property valuations.
Until interest rates stabilise, he said, transaction activity is likely to be low as investment decisions are postponed by REITs and projects are delayed.
“There may even be forced sales as interest-servicing costs bite and/or lenders become skittish over gearing levels,” Mazzarella said. “Perhaps counterintuitively, this bodes well for commercial property investors. This is a market where predictable and attractive yields are likely to become more highly prized than they were in 2022.
“Select global REITs … have the potential to provide investors with liquid access to a defensive real asset class with inflation-protection characteristics,” he added. “Best of all, right now many are available at appealing prices. After a tough 2022, the outlook for REIT investors in 2023 surely looks better.”
