Dexus (ASX: DXS) is a diversified Australian REIT that generates income from charging rent; managing property for clients; funds management, which typically includes property management and investment management services; and development and trading.

Dexus trades at an approximate 35% discount to our $10.80 fair value estimate and net tangible assets (“NTA”) of $10.88 per security (at 7 December 2023). That pricing implies: a 35% fall in NTA and values its intangible assets at zero; or a 50% fall in NTA and puts intangibles such as funds management on an approximately 10 times multiple of funds from operations; or the market factors a dilutive equity raise.

That all looks unlikely, given we expect the office supply/demand balance to slowly improve, management operations generated about a fifth of adjusted funds from operations in fiscal 2023, and the balance sheet looks solid.

Rent is the biggest revenue driver with the office and industrial divisions accounting for the vast majority of funds from operations. High-quality offices in Sydney dominate, with Dexus having interests in many trophy assets including Sydney’s 1 Farrer Place, and 1 Bligh Street. It also owns or manages a seasoned industrial portfolio, including the massive Dexus Industrial Estate in one of Australia’s fastest-growing industrial precincts, Truganina, Victoria. It also has a small retail portfolio, mostly retail sites attached to offices, and a small healthcare portfolio. Dexus has sold stakes in office, industrial and healthcare assets into funds management vehicles that it manages.

Office conditions will likely remain tough for several years given the weight of arriving supply, and mediocre demand, but narrow-moat Dexus securities price in more than enough bad news to look undervalued. Dexus pays a fiscal 2024 yield of roughly 7% against a 10-year bond yield of roughly 4.5%, which looks attractive while investors wait for recovery.

We expect new office supply to wane, given fewer projects kicking off, and onerous construction and capital costs. In September 2023, only 5.1% of Dexus’ office portfolio was due to expire for the remainder of 2024, and 10.7% in 2025, more moderate than the substantial leasing burden in 2021 and 2022.

Hybrid working is a demand headwind, but the brunt is being felt by low-quality offices. The Property Council of Australia measured office vacancy in non-CBD offices at 17.3% at June 30, 2023, compared with 12.8% in CBDs. Meanwhile, Dexus' vacancy was just 4.1%, explained by its portfolio of 95% prime-grade offices, 93% in CBDs, and 89% in the eastern seaboard locations. Its assets look well located for new rail projects, including Sydney Metro in 2024, which adds two new CBD stations and a 67% increase in peak train movements; the Melbourne Metro Tunnel in 2025, which adds rail capacity and two new CBD stations; and Brisbane Cross River Rail in 2026, which adds a second line and second station in Brisbane's CBD.