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Morningstar | Cut to Cromwell's Dividend Overdue But Positive. FVE Increases to AUD 0.98

Cromwell Property Group's fiscal 2018 operating earnings of AUD 156.8 million, or AUD 8.33 cents per security, and distributions of AUD 8.34 cps were in line with guidance. Our fair value estimate for no-moat-rated Cromwell increased to AUD 0.98 from AUD 0.95 on an improved outlook for rents across Cromwell's Australian office portfolio. Cromwell continues to screen as overvalued, currently trading at a 10% premium to our valuation.

Key share price catalysts are delivery on redevelopment opportunities such as the conversion of the legacy Tuggeranong office to aged care and the launch of new property funds. We have not factored in any upside with regard to the launch of new funds in our forecasts.

While conditions in office markets vary hugely across Australia, leasing conditions have materially improved in Sydney and Melbourne, and Brisbane is now on a positive trajectory. Cromwell has classified its office assets according to risk and quality, the highest quality being the core assets at 58% of the portfolio, followed by coreplus at 36%, and Active at 6%. A positive is rents and prices have been strongest for core office assets, the driver of revaluations and rents. Net operating income was up 4.6% for the 99.9% occupied core assets, well ahead of the 1.6% growth for the 96% occupied core-plus assets. We forecast this divergence to persist for the next two to three years.

Over the past year, Cromwell has taken advantage of the ongoing demand for yield by selling AUD 155 million of Australian office assets and its AUD 123 million stake in Investa Office Fund. This combined with a series of capital raisings, sees gearing down materially to 37%. This is still elevated, but compared with a year ago, provides a far bigger buffer should bond yields rise unexpectedly, pushing up wholesale borrowing costs. Following Cromwell's restructure of its debt book in July, refinancing risk is now low, with the next maturities being AUD 86 million of convertible bonds in fiscal 2020, followed by just AUD 1 billion in fiscal 2023. The average borrowing cost is a very low 3.3%, but looks set to rise over the next few years as hedging via interest rate swaps and caps, has a weighted average term of approximately 2.5 years.

Guidance for fiscal 2019 is for operating earnings to be no less than AUD 8.0 cps and distribution no less than AUD 7.25 cps. Guidance is on the conservative side, premised on maintainable transactional and funds management revenue and excludes any accretion from investments onto the property management platform. An overdue, but nonetheless welcome change is the reduction in the payout ratio of approximately 90% of operating earnings. This revision will see 10% of earnings reinvested in the business. We forecast fiscal 2019 earnings of AUD 8.3 cps, broadly flat on the current year, but have cut the forecast distribution to AUD 7.45 cps, a decline of 10.6% on fiscal 2018.