EUR 850.00 For Business Accounts Only

Morningstar | Change of Coverage of Mirvac; No Change to Our View

We reiterate our AUD 2.40 fair value estimate for no-moat-rated Mirvac Group following transfer of coverage to a new analyst. At current levels, shares screen as overvalued. While the firm owns a relatively good-quality portfolio of commercial property, it is higher risk than most AREIT peers because of its residential development business.

Mirvac's business strategy is to generate 80% of profit from passive investments via Mirvac Property Trust and 20% from development activities. Mirvac's strategy offers shareholders higher returns, with potential equity returns from development of 15%-20%, compared with 7%-12% from geared rental income. However, development is riskier and cash flows can be lumpy and unpredictable. Further, development lacks sustainable competitive advantages, leading to our no-moat rating.

Mirvac's investment portfolio has a book value over AUD 10.5 billion and comprises office (58%), retail (32%), and industrial (8%) properties. About 80% of the office portfolio is situated in space-constrained central business districts of Australia's major cities (Sydney and Melbourne), which benefit from barriers to entry because of a lack of vacant sites or suitable redevelopment land to construct competing offices. Additionally, we expect higher-quality CBD offices to have higher through-the-cycle occupancy, underpinned by the trend for successful businesses to upgrade to better premises. The remaining 20% of office assets are less attractive, being in city-fringe locations. Typically, these assets face higher vacancy risk but long lease terms, typically in excess of 10 years, to blue-chip tenants provide a high degree of earnings certainty.

Mirvac's retail assets are allocated among subregional (68%); CBD retail (24%); and neighbourhood (8%). We believe the growth rate for rents will slow from approximately 5% to about 3% during the next five years, as household balance sheets have become stretched and the Australian economic growth outlook appears anaemic. We also expect further growth in online retail, diluting sales of many tenants.

At the development level, the target is to have 80% of capital invested in residential developments and 20% in commercial projects. Overall, this allocation increases Mirvac's earnings volatility. Commercial developments are lower risk as they are typically more than 70% preleased before construction starts. Returns on uncommitted floors are fairly predictable unless demand for office space rapidly deteriorates. Residential returns are much more volatile, as precommitments are typically lower (about 50%) before construction commences and sales prices can fluctuate. This presents a risk of significant margin contraction in the event of declining home prices or from a more protracted sales cycle, which impacts holding costs. With mortgage rates at record lows and potentially going lower, Mirvac is well positioned to benefit in the near term. Longer term, though, we envisage headwinds from rising interest rates.