What happened in 2017?
2017 was a mixed year for the AREIT sector, delivering a 6% return. There were clear winners and losers, with the losers being the retail landlords such as Scentre (SCG) and Vicinity (VCX) that recorded -5% and -3% returns respectively. This was largely due to the expectation that Amazon and other online operators would decimate the Australian retail landscape, not helped by the lack of wage growth, and rising utility bills. The clear winners were industrial stocks and those with funds management platforms. Industrial became popular because online retailers need warehouse space, and fund managers received strong inflows to invest on behalf of offshore clients. Abacus (ABP) delivered 44%, Charter Hall Group (CHC) rose 34% and Goodman Group (GMG) rose 22%.
The big news for the sector came at the end of the year with Westfield (WFD) receiving a takeover offer from the French firm Unibail Rodamco (UL.NA). Unibail is the leading mall operator in Europe but doesn’t have exposure in North America or the UK. Westfield Corp is the opposite with malls in the US and London and thus seems a great fit for Unibail who are seeking to become "the world's premier developer and operator of flagship shopping destinations". Westfield had been the worst performing REIT to the end of November but the bid in mid-December saw the stock rally and deliver a 5% return for the year.
What is the outlook for 2018?
In terms of the year ahead, we're expecting single digit returns for the sector. The headwinds (negative) continue to be the retail sector, with tough conditions for retailers inevitably impacting rents. Bonds could also be a headwind, with Australian bonds strongly correlated to US bond movements. As a rule of thumb higher bond levels tend to see investors rotate away from defensives towards growth stocks.
In terms of tailwinds (positives), there remains strong demand for real estate assets. Australian assets offer some of the highest income yields globally and many recent sales occurred at levels above REIT valuations, suggesting understated AREIT NTA's. East Coast office remains a bright spot, with Sydney rents growing strongly, aided by infrastructure projects that has seen some buildings resumed. Industrial remains popular given that thematic of logistics playing a bigger role in Australia. Corporate balance sheets are in excellent shape with good debt capacity to fund buybacks. M&A will be a feature of CY18, with the Westfield deal plus other smaller transactions such as interest in PropertyLink (PLG). Finally, we should be getting some cash back mid 2018 as part of the Westfield transaction and part of this will be reinvested into the REIT market, supporting prices.
The key attraction for the sector is the 5% income yield that investors receive, which is well above the cash rate of 1.5%. When we add the expected growth of ~3% to this, we envisage a return of ~8% for CY18.
What is the impact of Amazon?
The retail sector has been impacted by a combination of cyclical and anticipated structural issues. Cyclically, retail sales have been under pressure due to higher living expenses (higher debt costs and utilities) which have grown faster than wages. Structurally, the market is anticipating much weaker conditions from online disruptors, albeit Amazon's launch in Australia was disappointing. However, there is no doubt that online sales will increase in Australia and it will impact landlords ability to charge higher rents.
Investors should note that REITs are landlords to the retailers, who have signed long term lease commitments, often with rental guarantees in place. These retailers are bound by contract and have to pay rent before they can pay themselves. The landlords work very closely with retailers to assess their situation and have dedicated teams to deal with potential insolvencies or trading difficulties. We think the major impacts will be felt by malls in secondary locations where retailers are ambivalent about their presence.
Pleasingly the REITs generally own trophy centres with strong demographics (high incomes, asset rich, growing population) and have sold most of the underperformers in the past few years. By way of example the REITs own Chadstone, Fountain Gate, Emporium, Sydney, Bondi Junction, Chatswood, Chermside, Carindale, Marion, to name a few. Retailers want to have a presence in those markets, with many having flagship stores in those centres.
Much of the negative news flow emanates from the US where there have been multiple store closures. Australia is different to the US in that we have solid population growth, much less retail space per person, tight planning laws and a non-discretionary focus in most centres. In terms of stock prices, the AREITs having ample balance sheet capacity to fund a share repurchase (buyback) and this should occur post the February results period.
In terms of industrial property, it is expected that online retailers and logistics firms will require new space or upgrade existing accommodation and this augurs well for the industrial landlords, in particular Goodman Group (GMG).
What does the Westfield deal mean?
Westfield (WFD) received a takeover approach by France's Unibail-Rodamco (UL.NA), to create "the world's premier developer and operator of flagship shopping destinations". This approach follows corporate activity in the US, with GGP Inc. (GGP.US) rejecting Brookfield’s $15bn offer to acquire the company. M&A fever is expected to continue and should provide a floor for other Australian retail landlords such as Scentre (SCG) and Vicinity (VCX). The Unibail deal offers unitholders a cash component (~⅓rd), with part of that expected to be reinvested back into AREITs. This will support the pricing of the sector.
Regarding the index impacts, the short answer is that Westfield will reduce in weighting but the degree depends on investors' actions. The starting point is that investors will receive ~⅓ of the share price back as cash, which implies the index weight could fall from ~14% to ~9% (with other stocks up-weighted). The nuance is that shareholders can choose Unibail-Rodamco shares that trade overseas, or Unibail-Rodamco CDIs that will trade on the ASX. Assuming ~40% of Westfield's shareholders are foreign based, and choose to take shares in the parent firm, then the weighting could be materially lower on the ASX. The beneficiaries will be "up-weighted" stocks like Scentre (SCG), Dexus (DXS), Goodman (GMG), etc. However, we await an official update from S&P regarding our logic on the potential index changes.
How does Australia compare to global markets?
Improved global growth has underpinned strong interest in physical real estate assets, with capital values in most markets lifting over 2017. Western Europe has witnessed strong office rental growth, the rise of ecommerce globally has aided industrial rents and values, while the US leads the softening of the retail asset class. The largest gains have been in German and Spanish residential names, while US retail names have suffered of late. The global outlook is mixed, with Asia and Europe expected to perform solidly, while the US is expected to be negatively impacted by further rate rises. This is due to the negative correlation on defensive assets pricing, with rotation occurring into growth assets as tax cuts aid businesses and the economy improves. This is likely to drag on Global performance given the US REIT market represents ~46% of the global index (FTSE EPRA/NAREIT Global Index). Risks to the upside are from further M&A, with a number of large transactions (in addition to Westfield's) announced at year end. These include Brookfield approaching the large US mall operator, GGP Inc. (GGP.US), with a $15bn offer to acquire the company. In Europe, the German residential property company Vonovia made an offer to buy BUWOG, an Austrian company which also has properties in Germany. The deal values Buwog at around €5.2bn. In the UK, Property developer Hammerson has made an £3.4bn offer to acquire Intu Properties, which owns and runs UK shopping centres. In Asia, China Vanke (2202.HK) has entered a deal to buy a portfolio of 20 retail assets in China from Singapore’s CapitaLand (CAPL.SP) for RMB8.4bn (S$1.3bn).
Against this backdrop, the Australian market compares favourably on a global stage given the following points:
- There remains strong demand for Australian assets, given the relatively high yields on offer versus other developed markets.
- In part this is due to the perception that Australia is a safe investment destination, with a relatively stable government, strong banking sector and tight planning practices.
- The underlying property fundamentals remain generally positive. The bright spots are the Sydney and Melbourne office markets and the East Coast industrial markets, while the Australian retail sector faces headwinds.
- On the retail front, Australia has much less retail space per person vs other markets, less reliance on department stores and population growth.
- Australian tenants sign long term contractual leases with annual increases which is not a feature of many countries.
These factors have seen AREITs outperform Global REITs and US REITs over three years, without the currency or political risk associated with offshore investments. Should the US lift rates as expected and their dollar strengthen (and AUD soften), then offshore demand will remain strong.