What's in store for property trusts?

Prior to the global financial crisis, many management teams in the Listed Property sector abandoned the core strategy of owning and managing quality real estate assets, keeping costs down and then passing this rent onto investors.

Such simple business was viewed as ‘boring' and ‘old fashioned'. Hardly the stuff to occupy the time of a high-flying property trust executive. So to liven things up – and justify some increasingly outlandish pay packages – management teams moved into funds management and traveled the globe, buying property in unfamiliar markets; all financed by cheap short-term debt to boost earnings per share.

Unwinding these misguided strategies was very painful for investors between 2009 and 2012, but it put property trusts on the right path. In the years following, listed property trusts have performed well, paying down debt and moving to sustainable distribution policies, making the most of the tailwind from rising asset prices and increasing foreign demand for Australian property. In Listed property trusts: party like it's 2007?, we looked at how the listed property trusts were being managed in 2007 and compared them with current conditions.

However, 2017 has marked a turning point in sentiment, as incremental gains from these positive factors have faded and new clouds have appeared on the horizon – notably the impact of Amazon on Australian retailers.

Despite these worries, the results from the sector in August were better than expected: a couple of major property trusts – Investa Office and Vicinity Centres – even announced on-market share buy-backs. As ever, though, different issues are affecting different parts of the market, so let's take a look a the various segments.

Retail

Discretionary retailers continue to face the challenges of online competition, a higher Australian dollar and slower inbound tourism. These factors have led to falling profit margins, particularly in clothing and footwear – reducing the pool available to pay rent.

As a result, investors have reduced their profit growth expectations for retail property trusts, which have consequently seen their share prices fall heavily. Scentre Group and Vicinity Centres, for example, are each down 26% since peaking in July 2016.

The shopping centre owners are fighting back, though, shifting their mix of tenants away from department stores and towards food, chemists and services such as personal grooming. While a pair of jeans or a book can be purchased easily on Amazon, it's harder to get a haircut. We expect the higher-quality Australian shopping centres to continue to provide their function as social hubs and service providers, although the less well located centres have more to fear.

Of course, these are longer-term issues, and in the meantime the retail landlords are performing much better than their share prices would suggest: occupancy is nearly full at 99.5% and they grew rental income over the last six months at an average of 3.1%. Amongst retail listed property trusts, the best result was from GPT Group, with rental income growth of 4%.

The threat from online competition is nothing new, but the imminent launch of the full Amazon offering in this country has brought it to the front of investors' minds. That may throw up some opportunities. Scentre Group, for example, is hovering around our $4 Buy price and we'll be providing a detailed update in the near future.

Office

In contrast to the uncertainty facing retail landlords, the Australian CBD office market continues to look solid for owners of office towers such as Dexus and Investa Office.

The key Sydney and Melbourne office markets (where most of the assets are located) have continued to benefit from stronger than expected demand. At the same time, the supply of new buildings has been constrained by limited new construction and the conversion of office towers into apartment buildings.

Against this background the office trusts were able to grow rental earnings by 4% over the past six months and increase occupancy to 96%. ‘Re-leasing spreads', which measure the increase in rent per square metre that an existing tenant pays to stay where they are when their lease expires, also increased 4% on average, with Dexus doing a little better.

Management teams in this segment generally provided optimistic outlook statements, expecting strong office markets in Sydney and Melbourne and improving dynamics in Brisbane and Perth. Second-tier suburban office parks are benefiting from the tight office markets in Sydney and Melbourne, which are pushing businesses to look for space outside the CBD.

Residential

Prior to the August profit results, we were concerned that the residential developers (Mirvac, Lend Lease and Stockland) would show rising defaults in completed projects from off-the-plan buyers that have paid deposits for apartments. A buyer may refuse to complete a sale (thus forfeiting their deposit) if, after completion, the value of the property has declined or the buyer has had trouble obtaining finance. Our concerns were allayed in August with the developers reporting minimal defaults and healthy forward sales.

Profit growth for the residential developers was very strong over the six months to June, courtesy of buoyant residential markets in Sydney and Melbourne. Mirvac reported an 11% rise in profits and Lend Lease increased profits by 9% and dividends by 10%. 

We remain cautious towards the residential developers, as the current record sales and profits will begin to abate in the near future. Over the next few years the developers will find it harder to maintain current profit margins, as their costs to acquire new land to restock their pipeline have increased and current profits are being sourced from cheaper land acquired a number of years ago. Additionally, new apartment buyers face higher debt costs as the banks pull back from lending to investors and offshore buyers.

Industrial                 

Industrial assets continue to be priced higher, and the underlying fundamentals appear to have improved in 2017. This is due to increased demand for Australian industrial assets from offshore buyers, tenants (especially those involved in transporting goods) looking for more space, and higher trading profits as the industrial trusts sell sites to residential developers.

Vacancy rates in major industrial property markets are falling as less new industrial assets are being brought to market. 

While conditions appear robust for the industrial listed property trusts, we are concerned about the sustainability of the current level of profits. In the year to June, for example, over 50% of Goodman Group's profits came from development profits, which are earned from both developing new industrial properties and selling excess industrial property that can be converted into residential developments. The market seems to be assuming that development activity will continue indefinitely, but at some stage the music will stop.

Summary

Overall, the view we put forward in Listed property trusts: party like it's 2007?, that the sector has significantly reduced its operational risks has been supported by the 2017 reporting season. The average level of gearing was reduced from 30% to 24% and management teams are conservatively sticking to running existing assets, rather than chasing offshore growth.

Continued high prices, however, can bring their own risk, and most of the sector remains closer to our Sell prices than our Buy prices. Goodman Group, Mirvac and Lend Lease, in fact, are all within 10% of our Sell prices. The obvious exception to this is retail, where sharp falls have put Scentre Group at close to our Buy price and Vicinity 5% away. Look out for an update on Scentre Group in coming days.