EUR 850.00 For Business Accounts Only

Morningstar | Transferring Coverage of No-Moat Charter Hall Retail REIT, AUD 4.20 FVE Unchanged.

We have maintained our no-moat, Standard stewardship, and medium fair value uncertainty ratings for Charter Hall Retail REIT following the transfer of coverage to a new analyst. We have also maintained our AUD 4.20 fair value estimate and, at the current market price of AUD 4.57, continue to believe the units are overvalued. Our fair value implies a fiscal 2019 P/E ratio of 14 and a distribution yield of 6.8%, versus a market price-based P/E ratio of 15 and yield of 6.2%. As a non-tax-paying trust, distributions are unfranked. Our forecasts assume an EPS CAGR of just 1.0% over the next decade, with only inflation like annual rental growth of around 2%, offset somewhat by rising interest costs.

We continue to view Charter Hall Retail as a moderate-risk property trust, based on the quality of its portfolio of 59 grocery-anchored small to midsize Australian subregional shopping centres. We still see smaller shopping centres as a relatively low-risk asset class. These properties will remain a key part of the Australian retail ecosystem underpinned by long leases to major supermarkets that offer a highly convenient shopping experience. The rise of online retail transactions means trading conditions are toughest for retailers selling discretionary items. However, as Charter Hall's tenants sell mainly nondiscretionary products or services, the firm's retail sales and rental performance are likely to outperform the broader market. With a diverse portfolio of assets throughout Australia, Charter Hall has numerous opportunities to redevelop assets to strengthen its competitive position, and hence its moat traits.

The trust offers defensive income based on nondiscretionary spending and high-quality tenant fundamentals, but these factors are partially offset by exposure to only one property subsector. It enjoys a high level of occupancy and tenant diversification, with about 50% base rental income secured by the top 10 tenants, including global top 30 grocery retailers, and only limited income from higher-risk development activities. The trust has a strategy to own well-located supermarket-anchored shopping centres, which drive customer traffic with management's recent focus has been on acquisition and redevelopment of subregional shopping centres.

There has been a clear bifurcation in the share price performance of retail real estate investment trusts in recent years. 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% to 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.