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Morningstar | Fixed Rental Escalators Provide Earnings Momentum for Growthpoint. FVE Unchanged at AUD 3.20. See Updated Analyst Note from 16 Aug 2018

Growthpoint Properties' fiscal 2018 earnings on a funds from operations, or FFO, basis of AUD 24.9 cents per security, or cps, were down 2% on the prior year. The fixed average rental escalator applying to approximately 90% of the portfolio continue to provide earning momentum, with weighted average rent reviews resulting in an increase of 3.3%. We forecast fiscal 2019 FFO of AUD 25.2 cps, up 1.5%. This is comfortably above Growthpoint's guidance (that has historically been conservative) of "at least" AUD 24.6 cps. The main reason for the slow earnings growth is a higher share count from the activation of the dividend reinvestment plan and some earnings dilution from planned asset sales. Distributions are expected to increase from AUD 22.2 cps in fiscal 2018 to AUD 23.0 cps in fiscal 2019, representing a yield of 6.1%. Our fair value estimate for no-moat-rated Growthpoint is unchanged at AUD 3.20 with the stock screening as overvalued, trading at AUD 3.75.

Major forecast revisions are the incorporation of the AUD 93 million purchase of a West Perth office property on a 6.25% yield, fully let to the Commonwealth government for further eight years, with rents rising annually by 3.75%. Letting risk across the portfolio is low in the near term with only 1% of leases expiring in fiscal 2019, but this increases to 11%, 6% and 21% for the fiscal years of 2020, 2022 and 2022, respectively. We have factored in office rents tracking broadly sideways on medium-term reletting. Market rents look set to grow solidly over the coming few years which should offset the negative effect of the 7.4% over-renting across the office portfolio. Both Sydney and Melbourne office markets have low vacancy rates and this combined with solid economic growth is putting upwards pressure on market rents.

Leasing outcomes for the industrial portfolio are not expected to fare quite as well, but we don't expect major rent declines on reletting even though the industrial portfolio was cited as being over-rented by 6.6%. The major rental risk is the very large distribution centres leased to Woolworths that are set to expire in fiscal 2022. These properties are situated in Broadmeadows, Melbourne; Gepps Cross in South Australia and Larapinta, Queensland. In total these represent 10.9% of the portfolio income. Growthpoint is hopeful the investment Woolworths has made in the buildings increases the likelihood the tenant will stay on at the premises. We don't share Growthpoint's optimism and believe the rapid innovation in logistics and the value of the Woolworths covenant could see the tenant moving to new premises, or at the very least, leveraging its covenant to have the landlord pay for costly upgrades.

Gearing is 33.9% at June 2018 and just below bottom of Growthpoint's target gearing range of 35%-40%. Similarly, net debt/EBITDA is approximately 5.7 times, high compared with most Australian REITs under coverage. We prefer more conservative debt settings, albeit acknowledging the use of higher leverage when borrowing costs are exceptionally low has helped Growthpoint achieve very strong returns for shareholders. The current level of gearing can be comfortably managed now as borrowing costs average around 4.4%. However, should there be dislocation in credit markets, Growthpoint is more exposed than most. The nearest major debt expiry is an undrawn bank facility of AUD 150 million in September 2020, with the next maturity being AUD 345 million of drawn bank debt, expiring in fiscal 2022.

Growthpoint continues to pay distributions around 5% to 10% above adjusted funds from operations. The firm is able to do this as it has been raising funds through willing participants in the dividend reinvestment plan. We don't see any particular merit in this approach to capital management for most shareholders.