Buoyant house prices underpinned Mirvac's interim profits for the first-half of fiscal 2020 but margins are at risk longer-term, says Morningstar.

Mirvac Group's newly inked deal to buy Nine Entertainment Co's headquarters in Sydney late last week opens up an almost $250 million opportunity for the company.

However, building and insurance costs are expected to rise and there are doubts Australia’s capital cities can maintain the surge in house prices, says Morningstar senior equity analyst Adrian Atkins.

Mirvac says its plan to repurpose the Willoughby site – which Nine has owned since the 1950s – will result in a "new community" of premium residences and high-quality buildings combined with large landscaped open spaces.

Residential contributes between 20 to 30 per cent of total group profits, the balance coming from Mirvac's growing portfolio of commercial property.

"The group's residential development segment remains the key swing factor for earnings overall," says Atkins.

Management says it is on track to meet earnings guidance for the full year, largely on the back of its residential division. It expects to beat the targeted 2500 residential property settlements in the 2020 financial year.

It last week reported $460 million ofearnings before interest and tax for the half, up 18 per cent on the same period in 2019.

Operating profit of $352 million was up 21 per cent on the same time 12 months ago.
Mirvac CEO and managing director Susan Lloyd-Hurwitz highlighted this rise in residential settlements as a primary driver of the result.

Good times won't last

But Atkins doesn't expect residential development to perform like this indefinitely.

"We think construction and insurance costs should rise in the wake of building quality problems in Australia’s apartment sector," he says.

"Further, even though many foreign developers have exited the market, Mirvac will likely have higher site acquisition costs than before."

House prices have surged but Atkins doubts the momentum will last.

"In our view, the rapid acceleration in dwelling prices from 2012 to 2018 is unlikely to be repeated. The current surge in house prices helps, but many drivers of the previous boom are no longer present," he says.

But Atkins insists it will be a soft landing: "We don't forecast a crash, simply a moderation".
This would see margins remain around the low- to mid-20 per cent range for the next one or two years, then dipping to an average of 18 per cent annually for the following half-decade.

"This is akin to margins the group was achieving around 2014/15 when the boom had begun, but was not yet full steam ahead," Atkins says.

E-commerce takes a toll

The REIT component of Mirvac contributes around three-quarters of the group's operating profit, valued at just under $12 billion. These are broken down across:

  • 60 per cent office
  • 30 per cent retail
  • 8 per cent industrial
  • Less than 5 per cent build-to-rent residential.

The office buildings are primarily A-grade assets in Australia's largest capital cities, particularly Sydney and Melbourne. Some of Mirvac’s flagship buildings include Chifley Tower and the EY Centre at 200 George Street Sydney; and its plan for a 55,000 square metre, 40-storey tower on 664 Collins Street, Melbourne.

Most of Mirvac's operations are considered defensive, given the high proportion of prime office assets with long average leases, annual rental increases and low vacancy rates.

"With CBD office space largely occupied by the finance, legal, accounting, and advertising industries, occupancy rates – and hence rents – are susceptible to slowing global growth flowing from debt issues in Europe and a lower Chinese growth trajectory," Atkins says.

On the other hand, Mirvac's retail property portfolio is under pressure, as bricks-and-mortar stores lose customers to online outlets.

  • The company's retail assets include:
  • regional (42 per cent),
  • sub-regional (23 per cent)
  • CBD (14 per cent)
  • Neighbourhood (9 per cent)

Broadway Sydney and Rhodes Waterside malls are examples of regional retail assets. Stanhope Village and Cherrybrook Village, both in Sydney’s northwest, are sub-regional and neighbourhood retail assets, respectively.

Mirvac's strategy is mitigating some of the damage e-commerce is inflicting on retail stores by re-focusing on urban areas and adapting mall designs. This includes more "non-retail" such as entertainment, dining and fewer departments stores, jewellery and homewares.

"Even so, we believe the growth rate for rents will slow from approximately 5 per cent to about 3 per cent during the next five years, as household balance sheets have become stretched and the Australian economic growth outlook appears anaemic," Atkins says.

Across the broader group, Mirvac's commercial developments are lower risk because they're around three-quarters leased before construction starts.

Residential returns are more volatile because less than half of new developments around sold before completion: this presents a risk of much tighter margins if house prices dive or sales volumes stagnate.

"With mortgage rates at record lows and potentially going lower, Mirvac is well positioned to benefit in the near term," says Atkins.

"Longer term, though, we envisage headwinds, either from rising interest rates or structurally lower sales volume or lower margins.”

Mirvac shares closed at $3.32 on Monday, about 35 per cent above Morningstar's fair value estimate of $2.50.