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Morningstar | Stellar Growth in Sydney Office Rents Continues Unabated. Dexus FVE Increases 5% to AUD 10.30

Dexus reported first-half fiscal 2019 earnings on a funds from operations, or FFO, basis of AUD 31.3 cents per security, or cps, up 3.6% on the previous corresponding period, or pcp. Growth in Sydney office rents have far exceeded expectations as low levels of vacancies have put the balance of power in lease negotiations firmly in favour of the landlord. Dexus management stated they have not seen evidence of prospective tenants being deterred by significant increases in rent. In fact, Dexus advised effective rents (face rents adjusted for tenant incentives) for newly negotiated leases in Sydney in the half year to December increased by 18% over prior rates. Management estimated rents across their Sydney office portfolio are currently 8% below market rates on average.

Much of this under-renting will be captured as 19% of Dexus’ office portfolio will be renegotiated in the Sydney market in the 2.5 years to June 2021. We’ve assumed Sydney office rents increase by approximately 10% over this period. We forecast office rents to increase slightly in Melbourne and decline for leases renewed in Perth and Brisbane over the next three years. The strong outlook for Sydney office rents and improved growth prospects in Dexus’ fund management activities is behind the 5% increase in our fair value estimate to AUD 10.30 from AUD 9.80. Nonetheless, narrow-moat-rated Dexus screens as overvalued, currently trading at AUD 11.70.

We suspect the main reason for the divergence in our fair value estimate and Dexus’ current share price is our view that effective office rents will retrace slightly over fiscal 2022 to 2025 in Sydney and Melbourne. We anticipate scheduled additions will significantly exceed organic demand, weighing on occupancy and hence market rents. We also expect a normalisation of interest rates, while the market appears to be pricing in lower for longer.

Dexus reiterated fiscal 2019 guidance for FFO per security growth of circa 3% underpinned by office like-for-like growth of 4-5%, industrial like-for-like growth of 2.5-3.5%, post-tax trading profits of AUD 35-40 million and maintenance and leasing costs of AUD 155-165 million. The guided distribution growth of 5% to AUD 50.2 cps implies a yield of just 4.3% at current levels.

At a headline level, it is pleasing to see Dexus’ gearing is one of the lowest among the Australian REITs under coverage at 23.7%. However, we caution that the modest gearing is almost entirely due to unconventional monetary policies triggering a search for yield that has materially boosted the values of office and industrial property. We are not predicting a disruption in global credit markets, but should this occur, this would weigh heavily on asset values and push up Dexus’ gearing. So on this basis, we support the currently more conservative leverage settings.

Aside from the solid growth in Sydney office rents, the next major positive is Dexus’ momentum in growing its funds management platform. Funds under management, or FUM, have increased to AUD 15 billion at December 2018 from AUD 5.6 billion in 2012. A large part of the growth is attributable to rising property values, with the balance a result of internal developments and acquisitions. Industrial seems the subsector with the strongest long-term tenant demand prospects, but we are seeing peers Stockland, Mirvac, Goodman, Charter Hall, and GPT Group all push to develop new industrial facilities to expand their FUM. We are forecasting ongoing growth in Dexus’ property management activities, but at a moderating rate due to the heightened competition for assets. Income from funds management represents approximately 7% of Dexus’ operating EBIT and is forecast to grow by 5% annually over the longer term, mostly driven by new developments.

Dexus’ development outlook increased significantly over the six months to December, with the pipeline increasing from AUD 4.2 billion in June 2018 to AUD 5.2 billion at December. The pipeline comprises AUD 2.8 billion on Dexus’ balance sheet and AUD 2.4 billion on behalf of third-party funds. We caution against getting too excited by the large increase as many of the projects are uncommitted or very long-dated, implying little prospect of medium-term earnings accretion.