Emma Rapaport: Hello and welcome to Morningstar. I'm Emma Rapaport. Joining us today is Alex Prineas. He's an equity research analyst with our Morningstar equity research team. Alex, thanks for joining us today.

Alex Prineas: Thanks for having me, Emma.

Rapaport: Alex, we're here to talk about property, not the sort of property that Australian investors are used to talking about, we're here to talk about commercial property. So, can you go quickly through your thoughts on how your sector performed during reporting season?

Prineas: Sure, yeah. I cover what's known as REITs, real estate investment trusts, as well as some property fund managers, property developers, and the airports. The major REITs typically, the landlords in major office buildings, major shopping malls. The biggest office landlord in Australia is Dexus. The largest and most well-known shopping mall REIT is Scentre Group, which operates the Westfield assets. There are, some of the larger property fund managers, Charter Hall and Goodman Group. There's plenty of other stocks in there as well across, the self-storage property sector, as well as convenience, retail that's more things like service stations, neighbourhood shopping centres and so on.

Rapaport: Your sector in particular is one that's been a little bit difficult to get an understanding of during the lockdowns. We're all stuck at home, obviously, we're not going to the office, we're not going to airports, things like that. And it's been a little bit hard to understand how the sector is performing. Can you tell us is there anything that you learned during reporting season, any highlights and lowlights from the commercial property sector?

Prineas: Sure. I mean, the highlight from the recent reporting season was how strongly some of the REITs performed in the June half of this year. It was a half where we saw not too much in the way of lockdowns. In fact, a lot of states in Australia were pretty much lockdown free, we saw a pretty strong bounce. So for example, Dexus leased more space in the half than it did in the same half in 2019. And we also saw groups like Scentre Group, the operator of the Westfield shopping centres, in a lot of the lockdown free states, such as Western Australia, South Australia, it reported sales at its -- among its tenants that were roughly about in line with pre-pandemic levels. So that's suggesting to us that once a lot of these restrictions are over with, and we've got a higher level of vaccination and so on. A lot of these property assets should perform, you know, there will be some areas that are slower to recover. But by and large, we think a lot of these assets are not impaired, and they should be able to get back to the levels they were trading at before the pandemic.

Rapaport: Yeah, so one of the reasons people like to buy these sorts of stocks are the distributions or the dividends that these companies pay out they're generally pretty stable. Have we seen that during reporting season as well, as you say that a lot of the sales have bounced back for the sector?

Prineas: Yeah, things are looking more positive there. So 2020 was really a year where a lot of the REITs, slashed their distributions or completely suspended them. And that was the right thing to do, we think, because of the level of uncertainty, also the level of impact to the incoming cash flow for many of these property trusts. So that was appropriate. Then 2021, we've seen REITs reinstating distributions, but typically at a lower level than pre pandemic, and also their forward guidance. So what the management is indicating is going to be the case in future, the forward guidance has either been non-existent or has been fairly conservative, which again, we think that's appropriate. We do think that, as restrictions continue to ease and the economy sort of continues to open up. Distributions have further room to grow. But we also would encourage investors not to necessarily anchor themselves to what the cents per unit distributions were on some REITs before the pandemic, it could take quite a lot longer for REITs to recover their income. Yeah, so that's kind of the way we're seeing things at the moment.

Rapaport: So I think it's fair to say that Australia is behind the rest of the world in terms of opening back up, you've been doing some research looking at the overseas experience of commercial real estate, sorry commercial and development space, is there anything that you've learned from looking overseas that can give investors a hint about what might be coming next, once Australia does look to open near the end of the year?

Prineas: You know, the fact that some parts of the economy are kind of bouncing back to pre-pandemic levels indicates that most other parts should eventually be able to bounce back as well. And, you know, on offices specifically, we've actually seen historically, some pretty big impacts on office demand, things like the increasing density within offices where more and more workers are crammed into sardine like conditions in some offices. And also the rise of part time work where previously someone might have used the desk five days a week, now they're using that desk two or three days a week, if they're in a part time role. These things seemingly would have had a very significant effect on office demand.

But in research that we sort of did in a report called, that we called, don't quit the city, the office is set for a comeback. We actually found that really, the biggest driver of office demand over time is the level of employment and particularly white-collar employment. And that a lot of these other factors, they have an effect, but they wash out over time. So we see the current setbacks for office as more of a cyclical downturn with some structural element. But in the long run, offices are a commodity, the supply can be adjusted upward or downward. Offices can be converted into apartments or hotels. And so we see that supply and demand as evening out over the long run, so it's important not to get too bearish.

Rapaport: Yeah, in terms of bouncing back, you've done some research to show that prices have really favoured property fund managers as opposed to REIT. Can you explain quickly the difference between those two investment structures? And why prices have favoured one over the other?

Prineas: Yeah, so if you look at the the ASX 200 REIT Index, it's actually now above the levels that it was just before it went into the pandemic back in, say January of 2020. But REIT investors really are still feeling like they're in a bit of pain. So that may raise an eyebrow. And the reason is that, actually the index, about a third of the index is made up of just two stocks, Charter Hall and Goodman Group. And they're actually property fund managers, more than REITs, and they've been going from strength to strength, just driving the index higher. Whereas the more traditional landlord REITs are actually still below the levels that they were just before the pandemic hit. So, if you are invested in those traditional REIT stocks, it's not surprising if you're still sort of feeling like you're a bit bruised by what's happened over the last couple of years.

But going forward, we actually think, well, you know, why would the institutional investors continue to come sort of head and fist into these direct property funds buying, effectively they have to buy into those funds at the net tangible asset level. When they can actually buy REITs at a discount to net tangible assets. And plus a lot of REITs actually have a development business or they have their own funds management business that is not even included in the calculation for net tangible assets because these are just earning streams. They're intangible assets. So essentially, we generally favour the REITs over the very established property fund managers, that have kind of been market darlings and the share price has really gone up quite a long way. Yeah, we think there's better value in the REITs at the moment.

Rapaport: Investors during reporting season don't get time to listen through every single earnings call, read through all the various reports and announcements. I'm curious from your month looking across your sector, was there any particular insight that you picked up maybe from an earnings call that maybe surprised you or something that a CEO or a management team called out that you could share with our viewers?

Prineas: I'd probably highlight our best idea for the sector, which is Lendlease. So as I mentioned, you know, the the market darling fund managers have been going from strength to strength, they're looking quite expensive. Lendlease has a combination of REIT business but it also has a funds management business that we think is -- so they're more of a contender in this space they've sold their engineering business, which has been causing them some very substantial losses. And those losses should eventually cycle out of the earnings. And they have a very large development business that, it's worth over $100 billion in terms of the end value of developments in a lot of key cities around the world. And so with this large development pipeline, they're actually going to be able to feed a lot of that into new funds management ventures and grow those more regular earnings streams.

So we think it will evolve from being a very volatile stock to one that's a bit more stable and more profitable. After they received a first strike from investors, from shareholders around the executive remuneration. They've actually increased the weighting of company equity that will vest gradually over time. So we think that the executive team there is quite well aligned with investors to be focusing on executing on those long-term development projects and generating returns for shareholders.