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Morningstar | Tight Office Market Glosses Over Slower Volumes in Mirvac's Residential Business. FVE up to AUD 2.20. See Updated Analyst Note from 09 Aug 2018

Mirvac Group's fiscal 2018 operating profit of AUD 15.6 cents per security, or cps, was up 8% on the prior year and at the top end of the guidance range of AUD 15.3 and 15.6 cps. Earnings going forward will be reported on a funds from operations, or FFO, basis. Guidance is for fiscal 2019 FFO growth of 2% to 4%, implying FFO of AUD 16.7 to 17.1 cps and distributions of AUD 11.6 cps, up 5% on fiscal 2018. We forecast FFO of AUD 16.7 cps, at the bottom of the guidance range. Following upgraded rental growth expectations for the Sydney and Melbourne office assets, our fair value estimate increases to AUD 2.20 from AUD 2.15, with no-moat-rated Mirvac slightly overvalued, currently trading at AUD 2.35.

It is prudent to call out that while we view Mirvac as overvalued, we view nearly all Australian property firms under coverage as overvalued. The current level of pricing for property of most classes points to ultralow bond yields persisting indefinitely, a view we struggle to reconcile given all the major central banks (with the exception of Japan) are taking steps to unwind extremely stimulatory monetary policies. These stimulatory policies combined with surging household and government indebtedness have spurred economic activity, driving down unemployment rates and most corners of the global economy have enjoyed a very long period of economic expansion. History tells us these periods of expansion (particularly debt-fuelled) will not run forever. The current pricing of most REITs doesn't appear to have given appropriate weighting to inherent risks ahead.

After successive years of strong growth, the residential development business of Mirvac has nosedived, with net sales for fiscal 2018 of AUD 980 million, down 32.5% on the AUD 1.45 billion in fiscal 2017. The value of residential presales going into fiscal 2019 is AUD 2.17 billion or down 21% from a year ago. While presales are influenced by a confluence of factors, it is hard to see a rebound given the sustained pressure on bank lending from the ongoing Royal Commission into banks. Other pressures to Mirvac's residential division include smaller banks raising mortgage rates due to higher funding costs and across-the-board tightening in bank lending criteria. Declines of circa 5% in Sydney prices has also damped sentiment and is likely to cause many prospective buyers to defer buying until they feel markets have stabilised. We are forecasting fiscal 2019 residential settlements are down 20% on the prior year, to 2,700 lots, broadly aligning with the 21% decline in presales going into fiscal 2019.

We don't foresee residential profits will fall by 20% as there will be fewer impaired lots in the sales mix and vacant land-lot prices in Melbourne are broadly flat to slightly positive. Two months into fiscal 2019, Mirvac has secured 60% of its targeted fiscal 2019 EBIT, which is below the 78% at the same time last year, indicating the residential sales team has a lot of work ahead to hit guidance.

The portfolio comprising office and industrial assets was the strongest performing division. Ultralow vacancies in the Sydney and Melbourne office markets are the major drivers of the like-for-like growth in net operating income of 12.7%. Mirvac estimated rents for its Melbourne and Sydney office portfolios to be below-market rates by 7% and 4.5%, respectively. This gap is likely to widen going forward as fixed ratchets will see rents rise by 3%-4% and market rents look set to rise by around 5% or more for the next two years. The relatively high near-term rental growth in the Sydney and Melbourne markets reflect the favourable combination of solid demand growth and limited new supply additions in 2018 and 2019. Upgraded cash flow assumptions for the Sydney and Melbourne office assets is the primary reason for the upgrade to our fair value estimate.

While office markets are exceptionally strong at present, we think caution is warranted as much of the growth appears to be linked to stimulatory monetary policies. These will eventually unwind, and not necessarily in an orderly manner, putting a dampener on office demand and rents.

We are circumspect as to the value that will be created from Mirvac's two new office developments. The targeted yield of 5.6% leaves too little buffer for unfavourable economic events and weak rental outcomes. Should yields on 10-year bond in the U.S.A rise materially over the next three years (which seems likely), this would weigh on end values and could see the deals being value destructive. The first to complete around mid-2021 is a 22,400 square metre office development in Sydney, with a cost of AUD 358 million. The second to complete in mid-2022 is a 50% share in a 57,800 office tower in Brisbane, with a total cost to complete of AUD 827 million. Mirvac currently estimates a yield on cost of 5.6% for both, with Mirvac's combined investment at AUD 775 million.

Mirvac's retail portfolio continues to outperform most listed peers with specialty sales up a comparatively strong 3.7%. The above-average performance is largely due to the high concentration to Sydney where the economy is growing very strongly. That said, we still don't have a complete view of the portfolio as around half of the assets are excluded from the comparison bucket having recently undergone development works.