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Morningstar | Goodman Foundations Are Strong But Share Price Looks a Bit Rich. FVE Unchanged at AUD 8.90. See Updated Analyst Note from 17 Jul 2018

Industrial property has been the standout performer among the major property classes over the past couple of years. A major reason is the weight of money following the evolution in the retail sector. Wholesale investors are seeing industrial as a good way to benefit from the shift in consumer spending from brick-and-mortar stores to online shopping. Industrial property values have been boosted by raised rental growth expectations as e-commerce tenants are willing to pay premium rents to operate from sites that deliver strategic supply chain benefits. Values have also benefited from the search for yield.

The surge in demand for industrial property has pushed down industrial property yields, which are at or near record lows. Goodman has played this dynamic well, offloading over AUD 11 billion of its less desirable assets over the past five years and redeploying the capital to build new assets, many of which are in strategically advantaged sites.

We've left our fair value estimate for narrow-moat-rated Goodman Group unchanged at AUD 8.90. Goodman shares screen as slightly overvalued, currently trading around AUD 9.80, having rallied 30% from its recent low of AUD 7.60 in February. The fiscal 2018 distribution payout ratio is 60%, with Goodman using retained earnings to coinvest with investors on its property management platform. Goodman expects the AUD 3.5 billion of developments in progress to generate an unleveraged yield on cost of 7.7%.

Our valuation is derived using a weighted average cost of capital, or WACC, of 8.45% for Goodman Group. If we reduce the return hurdle to 8.25% or 8.10%, this boosts the fair value estimate to AUD 9.50 and AUD 9.80, respectively, the latter aligning with the current share price.

There are a plethora of possible reasons why Goodman trades at a premium to our fair value estimate. We speculate that the investment community has got overly exuberant on the positive news flow following a series of large portfolio sales that transacted at very low yields. Sharp pricing is definitely a positive but we think it could be transitory, more a reflection of shortage of opportunities rather than the underlying fundamentals of each portfolio.

The value of third-party assets managed by Goodman has not risen as much as peers in recent years. This is due to Goodman divesting AUD 8 billion of property, roughly 25% the current AUD 31.5 billion in assets under management, or AUM. Goodman management believe they have very few assets left to sell in the medium term, which will result in a faster annual uplift in assets under management. This could be partially offset if property values fall, the most likely catalyst is the eventual upswing in interest rates as central banks unwind stimulatory interest rate settings.

Our fair value estimate is premised on a 10-year compound annual growth rate, or CAGR, in third-party AUM of 8%. This incorporates a 50 basis point increase in capitalisation rates used to value commercial property, detracting roughly 8% from AUM. If we adopt a higher 10-year CAGR growth of 9% or 10% and assume bond yields remain exceptionally low, we arrive at fair value estimates of AUD 9.40 and AUD 9.75, respectively, broadly in line with the current share price.

We are forecasting a 10-year rental CAGR across Goodman's global portfolio of 2.65%. This reflects very strong near-term rental growth of 5%-10% in South Sydney, roughly 5% rent growth in China and Hong Kong but rents to trend sideways in Japan and much of continental Europe. If we use more aggressive rental growth assumptions of 3% or 3.2%, we arrive at a fair value of AUD 9.40 and AUD 9.50, respectively. The change in the 10-year rental growth trajectory only has a modest impact on our fair value, as outer years forecasts (beyond 10 years) account for 65% of the valuation of Goodman Group.