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Morningstar | Rents Across GPT’s Broader Portfolio Constrained by Challenges in Retail. FVE up 6% to AUD 5.40

GPT Group reported 2018 earnings on a funds from operations, or FFO, basis of AUD 31.84 cents per security, up 3.5% and consistent with guidance. The AUD 5.9 billion office portfolio was the main driver, delivering 5.8% like-for-like income growth and to a lesser extent, the AUD 1.9 billion industrial portfolio, where like-for-like rental growth was 2.8%. The AUD 6.2 billion retail portfolio achieve hard-fought growth of 2.2% as sales in numerous malls were impacted by competitor expansions nearby.

We’ve upped the rental growth outlook and valuations attributable to the office and industrial portfolio and trim rental outlook and valuations for the retail assets. Our fair value estimate for narrow-moat-rated GPT Group increases 6% to AUD 5.40. With GPT Group trading around AUD 6.10, the stock continues to screen as overvalued. Our fair value represents a 3% discount to GPT’s reported net tangible assets per security of AUD 5.58. We suspect the main reason for our lower valuation is our reluctance to adopt prevailing discount rates which we view as inappropriately low, a result of ultra-loose monetary policies in Australia and abroad.

Guidance is for growth in 2019 FFO and distributions of 4%. This doesn’t seem a stretch given rents for the office portfolio contain an annual rental ratchet of 3.9% and rents for the 5% of leases expected to be extended should jump by around 8%. Further, while the office portfolio recorded a closing occupancy of 97% (including signed leases) the average office occupancy for 2018 was only 93%, providing scope for upside from higher average occupancy. GPT will also generate higher fund management earnings, as the fee base for 2019 increases by 5% to AUD 12.6 billion.

The major strategic change is GPT’s revised target weighting to office, retail and industrial of 40%, 40% and 20%, respectively. The changes equate to a 10% reduced weighting to retail shopping centres and a 5% increased weighting to both office and industrial. GPT had been gradually moving away from the old target weighting, so no surprise here. In recent years, the firm has been selling full or part stakes in many of the smaller shopping centres and developing and holding onto more industrial assets. We support the new target weighting as we see lower growth prospects for the retail assets. Nonetheless, this new strategic weighting is very much a me-too strategy, mirroring actions occurring by listed Australian peers Stockland, Mirvac, and Abacus to increased weighting to industrial and office. The only area where GPT is not following peers is the creation of a wholesale logistics fund.

We are not particularly optimistic about GPT’s focus on growing its industrial portfolio by AUD 150 to 200 million annually. Industrial is very much the "in-favour" sector. Valuations have spiked over the past two to three years as discount rates used by valuers fall and rents start to rise as growth in online retail has triggered supply shortage in Australia’s major east coast cities of Melbourne, Sydney and Brisbane. We don’t see GPT has any competitive advantage in logistics ownership or management. The firm’s relatively small industrial holdings mean it will have to competitively bid for development sites. By extension, this leaves little scope to generate returns above the cost of capital. With an industrial portfolio of AUD 1.9 billion, GPT is one of a group about 10 well capitalised developers who are not particularly differentiated in their offering of capability. This puts GPT a long way behind heavyweight owners and developers Goodman Group and Charter Hall, with Australian industrial portfolios of AUD 16 billion and AUD 6 billion, respectively.

The retail shopping centre portfolio was the only lacklustre area in the group portfolio performance. Management acknowledge shopping centres face a tough outlook and have been attempting to adjust by selling a handful of smaller centres. GPT had marketed Wollongong Central for sale, but following a poor response has no immediate plans to remark the asset with a AUD 485 million book value. We don’t see a clear catalyst for a rebound in Australian retail sales or rents, particularly for the regional assets where employment and wages growth outlook trails the larger cities of Sydney and Melbourne. We think a more aggressive stance on asset sales is warranted as there is a good chance that shopping centre values continue to fall over the next three to five years.

GPT booked very material noncash revaluations of AUD 911 million (AUD 0.50 per security) for 2019, which provided a source of collateral to enable GPT to make AUD 690 million of acquisitions and have gearing increase to 26.3% from 24.4% over the 2019. We view leverage settings as reasonable, pushed down by high stimulatory monetary policies that have boosted asset values.