Diverging value in Australia's real estate sector
One stock dominates Australia's A-REIT index and it has had an incredibly strong year. Our analysts see value elsewhere.
At first glance it might look like it’s been a stellar year for listed Australian property. After all, the S&P/ASX 200 A-REIT index has delivered a total return (share price and dividends) of over 25%. Look a bit deeper, though, and a different picture emerges.
By June 30 of this year, Goodman Group had grown to a 41.7% weighting in the S&P/ASX 200 A-REIT index. The stock has jumped by more than 70% over the past year fuelled by excitement about its strong position in data centres, a picks and shovels play on AI.
As we have seen recently in the US, this combination of a high index weighting and a big return can skew things by more than just a little.
The equal weighted version of the S&P/ASX 200 A-REIT index, where all 21 holdings get a roughly 5% weighting, is up 6.75% over the past year. Not too shabby, but not 25%.
Looking over the past three years takes us to a time before Goodman caught the AI and data centre tailwind. Over that period, the standard S&P/ASX 200 A-REIT Index has delivered a 7.3% return (again, mostly thanks to Goodman).
Meanwhile, the equal weighted property index is essentially flat.
This dispersion in fortune is reflected by valuations in the Australian real estate sector today. In this article we’ll look at three companies. Our analysts think that one is undervalued, one is fairly valued and one is signifcantly overvalued.
For an explanation of terms of like Fair Value, Moat and Morningstar Star Ratings used below, please see the foot of this article.
Goodman Group ★
Goodman Group is one of the world’s premier developers and managers of industrial property projects and investments. The group was co-founded in Australia by Gregory Goodman who remains CEO, and now has projects and customers in Asia, Europe, and the Americas.
A typical Goodman project involves obtaining a development site, signing tenants onto leases, and attracting investors who pay for the development and buy the completed project. Goodman typically retains a minority stake and continues to manage sites after completion, collecting development fees, leasing fees, management and performance fees, and a share of rent.
The group’s development pipeline has grown substantially, driven by the race to build e-commerce capability, modernize supply chains, and strong demand for data centers. Most of the group’s development projects end up in Goodman managed investments, boosting the group’s assets under management enormously.
Our analysts expect this to continue for the next few years as the race continues for the best logistics and data center sites. These are usually sites that are located closest to transport links and the end consumer, and that have power secured – something especially key for data centers. Goodman should benefit from its expertise, and its legacy holdings of property, many of which are close to urban centers and key infrastructure.
However, our analysts expect the remarkable returns to eventually slowdown to a more modest level. First, there is only so much existing property that can be sold and developed, before new sites need to be acquired, likely at substantially higher prices. Second, our analysts see much greater competition in future as many rivals are growing their presence in industrial property.
Our analysts have assigned a Narrow Moat rating to Goodman Group, which generates earnings about equally from three areas: management fees, development fees, and property investment.
Goodman’s moat stems mostly from switching costs for customers of its funds management business. Customers in Goodman’s funds management vehicles are typically locked in with redemptions allowed at fixed intervals, in some cases as long as seven years. Once money enters Goodman funds, it usually stays in for a long period of time.
In addition to sticky base revenues, they think that Goodman’s variable income (mostly performance, development and transaction fees) could remain elevated for the next few years. This could come from further e-commerce, supply chain and data center investments supporting demand for the kind of industrial property that Goodman specialises in. Goodman could also reap bigger profits from developing some of its larger data centre projects, for which it has already secured good locations and power supplies, with its own capital.
Our analysts see a lot to like about Goodman’s business. What they don’t like, though, is the current price of Goodman shares. At current levels of around $35 per share, it trades around 66% higher than our Fair Value estimate and commands a one star Morningstar rating.
Scentre Group ★★★
Scentre Group was created in mid-2014 by combining the Australian assets of the Westfield Group with those of Westfield Retail Trust. Scentre is predominantly a passive rent collector, but also undertakes development activities, constructing new centers and redeveloping existing assets, including recent developments in New Zealand such as Westfield Newmarket in Auckland.
With Scentre Group's malls consistently maintaining high occupancy of near 99% over the past 10 years, the assets have demonstrated strong tenant demand, which our analysts see persisting. Vacancies or rental abatements are a risk if social distancing preferences return, but our base case is that those will not return in our 10-year discrete forecast period.
Scentre’s rental earnings stability is aided by a long leases, on average. About 99% of Scentre’s rental income is derived from minimum contracted base rent, with only about 1% of rent linked to turnover. The REIT’s anchor tenants are generally signed onto lease terms of 15 to 25 years, while specialty leases average 6.8 years. In addition to rental income, Scentre earns about 10% of income from ancillary sources such as storage, car-parking and advertising.
Our analysts believe that Scentre has many of the best and most strategically located retail assets in Australia. They also view it as unlikely that rival retail developments could threaten most of Scentre’s assets. For these reasons we think retailers will continue to be located in Scentre facilities, with near full occupancy in most circumstances. However, our analysts fall short of assigning the company an economic moat. This is largely due to the threat of e-commerce to shopping malls.
Scentre has evolved in response to competition from online rivals. This has included increasing its weighting to food, entertainment and service categories that cannot be provided online. However many of these businesses cannot command the premium sales and rental rates that high margin fashion and electronics retailers historically delivered. Furthermore, some of these sub-segments, especially restaurants, have shorter leases, and more fickle customers. Our analysts think that Scentre will need to undertake more frequent refurbishments and lavish fitouts to attract visitors.
Another potential risk is that Scentre Group carries a lot of debt. Its interest coverage ratio as of Dec. 31, 2023 was 3.9 times, an improvement from 3.1 times at December 2020, but likely to worsen as fixed-rate debt expires and is replaced by higher-cost debt at prevailing interest rates. Our analysts think that Scentre’s debt level is manageable but could be reduced to lessen the risks of a stressed scenario.
At a current share price $3.30, Scentre trades at a modest discount to Morningstar’s $3.50 fair value estimate and commands a three-star rating.
Charter Hall Group ★★★★
Charter Hall Group (ASX: CHC) manages retail and institutional listed and unlisted property investments. It typically co-invests, aligning itself with its funds management clients. This gives Charter Hall diversified property exposure, so rental income produced accounts for about a fifth of the group’s EBITDA. A smaller portion of EBITDA comes from development, including development fees for managing projects for clients, and development profits on its own stake in each project.
Morningstar’s Brian Han ascribes a narrow moat to Charter Hall Group due to the funds management business, which generates roughly two thirds of earnings. In a similar vein to Goodman Group, switching costs make it unlikely Charter Hall’s customer base would make widespread redemptions in a short period. The group’s base fees more than cover costs, meaning that when nonrecurring revenues such as transaction, performance, and development fees arise, they can be lucrative.
Soft values for commercial property will likely weigh on near-term earnings as Charter Hall navigates the present cyclical trough, but the cycle should eventually improve. Values for retail and industrial properties have shown some resilience but office values are taking some big hits, and offices make up about one third of Charter Hall’s funds under management. Falling or stagnant property values undermine base management fees, and funds will be less likely to hit performance fee thresholds as property values fall.
Han assigns Charter Hall a Morningstar Capital Allocation Rating of Exemplary, based on a sound balance sheet, exceptional investment strategy, and appropriate securityholder distributions. The group avoided raising equity in the Covid crisis at the head stock level and, overall, Charter Hall’s investments have been lucrative for securityholders. The group has been acquisitive, even in hot markets, however most properties are purchased and developed on behalf of Charter Hall funds. This generates development, leasing, and management revenue, without taking on too much risk or requiring much capital.
Han’s Fair Value estimate of $16.25 per share makes Charter Hall's current price of around $12 look cheap. Although performance fees and funds under management growth will likely slow in the face of higher interest rates, Han thinks the market may be factoring in too much bad news.He thinks Charter Hall has growth opportunities as the property sector continues to move into the hands of fewer professional investors. Charter Hall's strong record and large management platform could see it benefit.
At a current price of around $12, Charter Hall shares trade at over a 25% discount to Morningstar’s Fair Value estimate and have a four-star rating.
Before you get to choosing investments, we recommend you form a deliberate investing strategy. You can read more about how to do this here.
Terms used in this article
Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.
Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.
Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.
