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Morningstar | Sturdy East Coast Office Demand Prompts Dexus Upgrade; FVE Increases to AUD 9.80

Dexus’s fiscal 2018 funds from operations, or FFO, of AUD 60.7 cents per security was up 3% on last year. Adjusted funds from operations, or AFFO, which is after maintenance and lease incentive costs, increased 5% to AUD 47.7 cents per security, aligning with growth in distributions. Dexus estimates rents across its office portfolio are currently 8% below market rates in Sydney and Melbourne. Assuming office demand remains solid, this will see large rent increases for the East Coast leases expiring over the next two to three years. Following raised office rental growth expectations, our fair value estimate for narrow-moat Dexus increases to AUD 9.80 from AUD 9.10. Dexus screens as broadly fairly valued, currently trading around AUD 10.40.

Guidance is for FFO to grow 3% in fiscal 2019. Lower leasing and maintenance costs result in guided AFFO growth of 5%, with distributions to rise in step. We forecast distributions of AUD 50.2 cents per security, implying a yield of 4.8% at the current security price.

At a headline level, gearing remains conservative at 24.1% on a look-through basis, although this metric has been flattered by high asset values. The weighted average capitalisation rate used for valuing the office portfolio is 5.37% and 6.4% for the industrial portfolio. Interest coverage is robust at 4.9 times, providing strong cash flow coverage when borrowing costs eventually move to more neutral settings. Net debt/EBITDA for the year to June 2018 was 4.2 times, a slight deterioration on the 3.8 times a year prior. Net debt/EBITDA, incentives and maintenance costs was 5.3 times. Both are expected to remain at current levels for the next two years while Dexus deploys capital to the development opportunities.

The Sydney central business district, Sydney Metro, and Melbourne CBD office markets--representing 59%, 11%, and 8% respectively of Dexus’ office portfolio--continue to overshoot expectations. Tenant demand is robust and new supply muted, a very favourable combination causing rents to surge. Vacancies in both the Sydney and Melbourne CBDs are around 4%, and barring an unforeseen event, they will likely remain below 5% until 2021 when there is a pickup in new supply. We’ve assumed effective market rents decline for three years from 2022, when new supply is delivered and landlords are compelled to cut rents to lease vacant space.

Performance for the industrial portfolio is respectable, with occupancy high at 98% and effective rents rising 3% during fiscal 2018. Industrial has favourable demand underpinnings from growth in online retail, but a surge in supply is dampening rents in some corridors. Dexus isn’t immune, with the rents across the industrial portfolio now slightly above market rates, tempering medium-term rent growth to approximately 2%.

Separately, we’ve slightly raised medium-term profit expectations for Dexus’ speculative development activities. Dexus has guided for fiscal 2019 post-tax development profits of AUD 35 million-AUD 40 million and AUD 260 million-AUD 280 million of pretax profits over the period to 2024, or roughly AUD 55 million annually.