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Morningstar | Dexus Benefits from Peak Sydney and Melbourne Office Conditions. FVE Unchanged at AUD 9.80. See Updated Analyst Note from 05 Nov 2018

Trading conditions in the major Australian CBD office market in Sydney and Melbourne are close to ideal. Federal monetary policies remain on stimulatory settings and Australia’s two largest cities continue to benefit from buoyant business conditions and multiple large transport infrastructure projects. The need to house the design and delivery teams on these projects has accentuated the existing shortage of office space. Further, Sydney’s rail upgrade works has resulted in the demolition of multiple buildings causing a shortage of supply and a jump in office market rents. A series of new offices are under development, but most are not scheduled to be delivered until after 2020.  Accordingly, for 2021 and a few years beyond, we forecast Melbourne and Sydney office rents to face significant downward pressure as the supply of new offices exceeds organic demand.

Our earnings forecasts and AUD 9.80 fair value estimate are both unchanged. Narrow-moat-rated Dexus screens as fairly valued, currently trading in line with our fair value estimate.

Major assumptions underpinning our valuation are a weighted average cost of capital of 7.3%, occupancy across the office portfolio averaging 95% over the next decade and office rents growing over next decade at a CAGR of 2.45%. Our rental CAGR assumptions are below the 3%-4% escalations implicit in many tenant leases as our 10-year forecasts incorporate a period of economic contraction causing landlords to discount rents or offer rent incentives to secure tenants. This is consistent with long-term trends when markets periodically become oversupplied, as is currently the case in the Brisbane, Perth, Canberra, and Adelaide office markets.

Three months is a short time in commercial property, so Dexus’ operational update for the September quarter revealed no major changes since the fiscal 2018 results. Occupancy across the office portfolio ticked up 1% to 96.6% and the weighted average lease expiry, or WALE, was stable at 4.6 years. The results were similar for the industrial portfolio, with occupancy just under 99% and the WALE at 4.9 years. Dexus executed only one transaction of significance, that was the sale of 32 Flinders Street, Melbourne, locking in AUD 49 million of foreshadowed pretax trading profits. Transactions of this type flatter Dexus’ earnings, but are immaterial in the context of a business with a market capitalisation of AUD 10 billion. Further, with pressure mounting for global interest rates to rise going forward, these transactional gains look set to become more elusive.

Separately in early October, Dexus invested AUD 11 million to acquire 28.5% of Heathley Limited, the external manager of the Heathley Healthcare REIT. Heathley Limited is planning to have the REIT listed, with a portfolio of 42 assets and a book value of AUD 528 million. The transaction to acquire a stake in the manager is immaterial at this point, but provides a low-cost growth option given the strong growth outlook in the Australian healthcare industry. Dexus retains an option to acquire a further 21.5% interest in Heathley in the future. Dexus already has presence in Australian healthcare funds management, having launched the Healthcare Wholesale Property Fund, or HWPF, in December 2017. If HWPF is successful in its second capital raise, funds under management will approximate AUD 830 million.