EUR 850.00 For Business Accounts Only

Morningstar | Arena REIT Through the Eye of the Storm. See Updated Analyst Note from 17 Dec 2018

No-moat Arena REIT securities have performed well over the past couple of months following comments from childcare operators that childcare center occupancy rates are starting to improve. However, at the market price of AUD 2.45, Arena is now fairly valued. This means we expect the stock to generate a total return equal to the cost of equity of 7.5% over the next year, a fair return considering the risk of investment. Alternatively, Charter Hall Education Trust, which has very similar attributes, including a 4% stake in Arena, trades 10% below fair value and is our preferred pick of the childcare REITs.

We weren’t particularly surprised to see Think Childcare and G8 Education announce improving occupancy rates in November as we’ve long thought the Childcare Subsidy, or CCS, would provide a boost to the industry. Before the news, we believed the market was unjustifiably extrapolating weak occupancy rates, an oversupply of child care centers, and potential consequences for the leveraged business models of some players. Aside from CCS benefits, we’re also of the view that G8 Education, which composes 8% of Arena’s portfolio, has improved its corporate culture significantly over the past couple of years, which is helping drive more rational behavior in the industry.

We continue to believe that the industry has favorable long-term attributes, such as a growing population of children between newborn and 5, and a long-term commitment from the federal government to support the sector financially. We also consider the new CCS to be more favorable than the previous subsidy regime and we expect this to drive higher childcare center occupancy rates and support fee growth which should underpin occupancy rates for the REITs.

From the landlords’ perspective, improving occupancy rates are positive but less beneficial than for the operators. Landlords already have strong and defensive businesses due to their standard 15-plus years leases, and the defensive nature of child care services which are largely funded by the federal government. The oversupply of child care centers has also led to a withdrawal of lending for new developments, in addition to broader credit tightening triggered by the Financial Services Royal Commission which will benefit existing providers.

We forecast a 4.2% CAGR for distributable income over the next decade, below the 10% CAGR achieved over the past five years. However, around half of the recent growth has come from developments and acquisitions and we don’t incorporate developments or acquisitions beyond what’s been announced by the company. This approach was vindicated over the past year as the oversupply of childcare centers led to a reduction in activity by the listed REITs, causing many analysts to reduce overly optimistic forecasts. While we expect Arena to eventually increase development and acquisition activity, it could be a year or two before the market fully absorbs the current oversupply.