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Morningstar | REA Group and Domain’s Strong Long-Term Outlook Unaffected by Real Estate Downturn

We expect real estate price weakness to weigh on the narrow-moat-rated real estate advertising platforms, REA Group and Domain, in the short term but not materially in the long term. Australian real estate prices fell by 4.8% in 2018 but the national figure masks significant regional differences, with prices in state capitals falling 6.1% but regional areas down just 0.2%. Similarly, Sydney and Melbourne fell by 8.9% and 7.0%, respectively, but Hobart and Canberra rose by 8.7% and 3.3%, respectively. The Sydney and Melbourne markets reached record house price/income ratios in 2017 and are the main cause of the current weak national performance.

Although we don’t explicitly forecast real estate price levels, we expect rising rental yields to eventually support prices, barring an increase in unemployment. Gross rental yields have increased to 4.0% nationally, from a low of 3.7% in 2017, which is already reasonably attractive relative to the Reserve Bank of Australia’s base rate of 1.5%. In Sydney and Melbourne, yields are 3.3% and 3.5% respectively, but still reasonable relative to the base rate, especially as futures markets are increasingly implying an interest rate cut.

However, both platforms are primarily dependent upon real estate turnover and listings, rather than prices, which is being impacted in the short-term but should increase with population growth in the long term. We also expect the platforms to increase their share of real estate marketing fees which are still significantly below real estate agent fees, and which will also support earnings growth. Our preferred exposure currently is Domain which has fair value estimate of AUD 2.80 and a price/fair value of 0.81, versus REA’s fair value estimate of AUD 59.00 and price/fair value of 1.31. Our fair values imply a higher fiscal 2019 price/earnings ratio for Domain than REA because we expect a temporary fall in Domain’s earnings in 2019 and relatively strong earnings growth beyond.

We don’t expect REA to become a monopoly. The company is the leader in the Australian real estate platform market, generating around three times Domain’s comparable revenue, and was aided by an early mover advantage and protected by a network effect-based narrow economic moat. Network effects usually result in near monopolies, like Facebook, but come in two types and REA has the weaker of the two. REA’s network effect is ‘two-sided’ meaning the company facilitates connections between buyers and sellers but not between buyers or between sellers. In contrast, Facebook has a stronger ‘Direct’ network effect as it facilitates connections between all users of its platform. In addition, the real estate listings on REA’s platform are usually available on competitors’ platforms also, in contrast to eBay or Amazon, meaning REA’s main value proposition is its large real estate focused audience of buyers.

REA’s two-sided network effect provides a competitive advantage over most firms but has been insufficient to stop Domain’s rise. As a subsidiary of Fairfax, Domain has been able to leverage Fairfax owned mastheads, such as the Australian Financial Review and Sydney Morning Herald, to subtly advertise its platform and create a real estate focused audience via editorial content. Although Domain is now independently listed, Fairfax retains a 60% stake and the acquisition of Fairfax by Nine increases the range of media assets for Domain to leverage. This should support Domain’s audience growth and justify higher listing fees which underpin our strong earnings growth outlook.

Although we expect Domain to survive and thrive, we don’t expect this to come at the expense of REA’s earnings growth. Both platforms charge around 0.2% of the property value which is well below real estate agents’ fees of around 1.5% to 2.0%. Historically agents could justify their fees as they effectively created a local real estate marketplace. However, the market place is now created by the platforms meaning they should capture more of the value. REA has steadily increased prices in recent years which has enabled the company to avoid any impact from the real estate downturn so far and we expect price rises to continue. Although REA may cede audience market share to Domain, we expect the increase in the addressable market to enable both companies to continue to grow profits.