Vicinity comes close

In Getting a Hold on property trusts, back in 2016, we explained some basic truths about valuing property trusts.

In simple terms, you can add your expected long-term average growth rate to the distribution yield to give an anticipated long-term return. You can then decide whether that's enough for you, based on the quality of the particular trust and the risks being taken.

Of course you'll only get that return if the assumptions are correct and you hold forever; the sooner you sell, the more of your actual return will be determined by the fickle nature of the market and the value it places on the income being generated. But it provides a basis for assessing the sector.

We also explained in that article that, given the range of investors' needs, it was likely that most of the sector would be Hold recommendations most of the time (with our Buy and Sell recommendations reserved for when we think everyone should consider buying or selling a stock). Shopping centre owners Scentre Group and Vicinity Centres were both firmly in the Hold category, although Vicinity had been flirting with a downgrade to Sell.

Yet here we are less than two years later and we've already put a Buy on Scentre and Vicinity is hovering around our Buy price. So what gives?

Twin threats

Amazon is the short answer; and Amazon and rising global interest rates is the long answer. When the available yield on other assets rises (notably the safe ones like government bonds), then the yield on everything else tends to rise in sympathy – most conspicuously on so-called income stocks, including listed property trusts. With distributions from property trusts relatively static, this means their prices have to fall.

We've been sceptical of the very low bond yields of recent years, though, and haven't allowed our required investment returns to follow them all the way down. That explains the slim pickings on our Buy list – and also why our own valuations for property trusts have moved by less than the market's.

On top of rising bond yields, retail property trusts have been hit by the threat of online retail and of Amazon in particular. In a few years' time, the story goes, we'll all be sitting at home in our pyjamas buying anything from groceries to clothing to electronics. And all the shopping centres will be empty.

Online threat overdone

Of course no-one really believes that, but even if it's only partly true, it could have far-reaching consequences for the likes of Scentre Group and Vicinity Centres, which own a large share of the nation's shopping centres.

We explained why we thought the risks were exaggerated in Price slashed at Scentre Group in October last year, laying the groundwork for February's upgrade of Scentre to Buy. Our case for Scentre also revolved around its superior quality, with its premier city centre locations well placed to shift towards things like food, services and entertainment that are harder to provide online.

Vicinity is harder to pin down, with almost half its value coming from some of the country's premier retail assets, including Chadstone in Melbourne (the largest shopping centre in the Southern Hemisphere), as well as Chatswood Chase, the Queen Victoria Building and the Strand Arcade in Sydney. Much of the rest, though, comes from smaller ‘sub-regional' centres, such as Albury's Lavington Square and Karratha City in Western Australia.

The overall result is a group whose top two tenants are Coles and Woolworths, each contributing around 4% of income (followed by Kmart (3%), Myer (2%) and David Jones (2%)). Scentre Group's tenants, by contrast, are led by Myer and David Jones (with Coles and Woolworths down in sixth and seventh place by floor space, behind discount department stores Target, Kmart and Big W).

Myer's mess

There's been much discussion in the press about the impact that Myer's very public problems might have on shopping centre landlords. Whilst Myer does take up a large and prominent amount of space in many centres, they are invariably one of the lowest rent payers per square meter.  That's because when the leases were signed (often over a decade or more ago), it was thought necessary to have large department stores in a shopping centre to drive foot traffic.

Over the past decade, though, the importance of department stores has dramatically decreased. So, while Myer currently represents only 2% of Vicinity's rental income, it takes up close to 8% of its space. Arguably both Vicinity and Myer would benefit from the ailing department store handing back retail space, which could then be given to more productive tenants such as JB-HiFi.

In February 2018, Vicinity reported a solid if unspectacular result, although distributable profit fell 2% and the distribution per share fell 7% in line with expectations. Net tangible assets (NTA) per share increased to $3.09, although that number is subject to the assumptions the accountants use to value the portfolio.

The highlight from the result was probably the deal to swap a 49% share in the Chatswood Chase shopping centre in Sydney, for half shares in, and management rights to, the Queen Victoria Building, The Galeries and The Strand Arcade.  This is all part of management's efforts to shift its portfolio up the quality scale and overall we applaud their efforts. There's a long way to go, though, and in the meantime the concerns have pushed Vicinity firmly into the bargain bin, with its share price falling by a third in the past couple of years, pushing its distribution yield up to 6.8% (albeit unfranked).

Higher yield justified

That's well ahead of Scentre Group's 5.7%, but a high yield is justified. For one thing, we'd expect Scentre to grow distributions a per cent or two more quickly over the long term due to the better overall location of its portfolio. That puts Scentre in a better position for any required shift towards services and entertainment, but it also provides a backstop value for the properties if the impact from online retailing is more severe than we expect.

The higher quality portfolio also makes Scentre Group the less risky of the two stocks, despite slightly higher gearing (Vicinity's net debt stands at 27% of net debt plus NTA, while Scentre will move from 32% to 34% if it completes the $700m buyback it announced yesterday).

With Scentre already in our shopping bag, we're inclined to be greedy with Vicinity and we're reducing our Buy price to $2.30. Members with a particular need for income might choose to pay a little more than this, although at current prices our preference is for Scentre Group and we'd be cautious of taking too great an overall exposure to retail property trusts. HOLD.

Intelligent Investor is loading up the van and going on tour in April and May, with events on the NSW central and north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. If you'd like to hear us talk about building a portfolio to weather any storm, book your spot here.

Note: The Intelligent Investor Equity Income Portfolio own shares in Scentre Group. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in Vicinity Centres and Scentre Group.