Westfield Pt III: The view from above

‘It is a capital mistake to theorise before one has data’, advised Sherlock Holmes, ‘insensibly one begins to twist facts to suit theories, instead of theories to suit facts.’

The data as it pertains to Westfield Group concerns the impact on the business in the event of Australian retailers achieving rent reductions, as discussed in Part 1. That analysis has already prompted a downgrade of Westfield Retail Trust (see Part II). That's because with a predominantly Australian portfolio, it would bear the brunt of any falls should history show that current rents in Australia are unsustainably high.

Here, we’ll focus on Westfield Group, which for two primary reasons happens to be a very different beast.

First, whilst Westfield Retail owns a portfolio of primarily Australian assets, Westfield Group’s portfolio is far more diverse. Only 36% of its portfolio rests in Australian assets (see Chart 1). The remaining 64% is split principally between the US and UK.

This diversity offers a buffer from any fall in Australian retail rents, although were the US and UK to incur rent falls this diversification would count for naught. Of more importance are the specific markets in which Westfield Group operates and the opportunity for growth within them. Then there’s the comparative cheapness of the rents it charges in these markets.

That’s a crucial point. Based on recent RBA data, Australian commercial real estate, which includes retail property such as shopping centres, is around 50% more expensive than in the US and UK. It isn’t just that Westfield Group owns a diverse portfolio but also that it’s filled with reasonably priced assets charging much lower rents on a comparative basis.

Improving quality

The company has been exploiting cheaper assets prices and weak conditions to extend its reach. Recently, for example, it has expanded into Brazil via a $440m joint venture with Almeida Junior and to Milan, where it is currently developing Europe’s largest shopping centre. It’s a counter-cyclical approach that supports the view of an impressive, coherent growth strategy.

Moreover, Westfield has been improving the quality of its portfolio by selling regional US assets and focusing more on ‘destination’ retail centres such as its current project at the World Trade Centre site in New York. With a more diverse, cheaper and increasingly higher quality portfolio, it’s easy to appreciate why Westfield Group is a different beast to Westfield Retail.

Such differences are reason enough to retain a positive view of the business. But Westfield Group also benefits from its deep experience in property development and management over its 52-year history.

Recently, for example, it signed a lucrative 17-year agreement to manage retail space at Los Angeles Airport, the sixth busiest in the world. These fees, plus any development profits, provide a nice bonus that doesn’t accrue to Westfield Retail.

Clear growth path

Strategically, this business has a clear growth path and is rich with opportunity. But what would happen to it if it did suffer rent revenue falls? That, after all, is the greatest threat to this business.

Table 1 models a steep 30% decline in Australian speciality store rents as leases roll off and vacancies jump 5%. It also factors in a meagre 2% rent gain in overseas rents. On that basis, the cash yield drops from 6.9% today to 4.8% by 2016, a fall of around 30%. That’s a long way short of the 60% decline faced by Westfield Retail security holders. This is, however, no means a worst case scenario and if the US, for example, were to enter a deep recession the downside could be considerably worse. 

The situation becomes even more pronounced in Table 2, which models a decline in Australian speciality store rents of 20%, stable occupancy of 99.5% and the same gains in overseas rents as Table 1. In this case the impact is far less severe with the cash yield in 2016 only dropping to 5.8% from 6.9% today. In comparison, Westfield Retail would suffer a fall of around 25%.

Both cases highlight a fundamentally different outcome to that of Westfield Retail (download this Excel spreadsheet to fiddle with our assumptions). Furthermore, each scenario doesn’t assume any Westfield Group income growth from future developments. As recently completed projects like Stratford City, adjacent to the London 2012 Olympics site (see image) ramp up, income should grow.

Muted impact

Australian rent declines should therefore have a muted impact on Westfield Group, but we’ve lowered the prices in our recommendation guide and decreased the portfolio weighting to 5% to reflect our more conservative view.

Remember, too, that members should keep their total exposure to both Westfield stocks to no more than 7%, with a heavier weighting to Westfield Group (e.g. 2% in Westfield Retail and 5% in Westfield Group). If you own both stocks we recommend reducing your exposure to match these new portfolio limits. 

Despite this, Westfield remains the best retail property group in the world. It continues to demonstrate skill in building high-quality assets that yield excellent results by pursuing a gradual, counter-cyclical approach to expansion.

Since taking over from Frank ‘Qatar shouldn’t have won the World Cup’ Lowy in 2010, Steven and Peter Lowy are responding well to shifting consumer preferences. The shopping centre concept as we have come to know it is changing, and that change is being brought about by Westfield.

With the security price up 12% since 10 Nov 11 (Long Term Buy – $7.86), and owing to our reassessment we’re downgrading a notch to HOLD.

Note: The model Income and Growth portfolios owns securities in Westfield Group.