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Morningstar | Charter Hall's Focus on Smaller Malls Still Has Drawbacks; FVE Unchanged at AUD 3.90. See Updated Analyst Note from 07 Dec 2018

We continue to view no-moat Charter Hall Retail as overvalued, with the stock trading around AUD 4.60 versus our AUD 3.90 fair value estimate.

Over the past year there has been a clear bifurcation in the share price performance of retail real estate investment trusts. Those that own predominantly smaller convenience-based malls (Charter Hall Retail and SCA Property) with mostly nondiscretionary retailers have delivered significant share price outperformance compared with REITs focussed on larger malls (Scentre Group and Vicinity) in the major cities.

The key reason for the divergence is the market's attraction to the defensiveness of the smaller malls, where anchor tenants--mostly supermarkets--contribute 40%-50% of the rental income. The balance comes from small specialty retailers that have little competition in the centre, such as cafes, beauty salons, and medical services. Conversely, the investment community has soured on the outlook for larger malls due to the loss of sales to online retailers and the deteriorating outlook for the high-rent-paying small apparel tenants.

We also see problems ahead for the larger malls, but think the smaller malls favoured by Charter Hall, most of which are in regional parts of Australia, face other challenges that will weigh on rent growth. First, the supermarket chains are locked in a price war that will weigh on sales and hence diminish the rate at which their rents increase each year. Second, the supermarkets are systematically expanding into traditional specialty categories such as fast food, bakeries, pharmacy products, and florists. This hurts sales of these smaller retailers in these categories and hence the ability of the landlord to raise rents. Third, the smaller malls favoured by Charter Hall and SCA Property are generally in regions of Australia where the population growth rate is low and household income growth is below that of the larger cities. We see the low level of employment and wages growth in regional Australia as translating into bottom-quartile sales growth for Charter Hall, with a similar impact on specialty rents. Finally, the smaller malls are very susceptible to the opening of a stand-alone supermarket nearby. The risk of this is increasing as Aldi and new entrant Kaufland have a preference to own their stores rather than rent.