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Morningstar | The Falling Residential Knife Stabs at Stockland. FVE Falls to AUD 4.15

Conditions in the Australian housing market have turned south far quicker than we were expecting. Pressure is coming from vastly tightened bank lending standards, a collapse in demand from offshore buyers and the delivery of a swathe of apartments, particularly in Brisbane. We generally don’t put much stock in the inherently volatile auction clearance rate, but with the capital city clearance rate systematically falling over 2018 and most recently reported at 54% (a six-year low) the clearance rate metric points to further declines in dwelling prices. First homebuyers are presumably being advised to defer their purchase decision, putting pressure on vendors to further drop their expectations to secure a sale.

The weakening housing market is a negative for Stockland, hurting margins on existing and upcoming residential projects. The negative sentiment has reared its ugly head in residential pre-sales. The 1,293 residential deposits booked for the September quarter was down 23% on the prior corresponding period and the lowest sales rate since the December quarter 2012. The slower sales rate not only pushes out profit on development sites to subsequent years, but impacts margins as the more protracted sales cycle results in higher holding costs per lot.

We see margins remaining above 15% for residential development over the next few years given most of the firms residential landbank was secured at prices materially below current market prices. Stockland also has a better chance of securing committed buyers as smaller developers are struggling to secure bank finance. Even through Stockland will grow market share, this is cold comfort given the downward pressure on margins and volumes. Cuts to the residential earnings outlook and raised expectations for the long-term cost of debt are behind the reduction in Stockland’s fair value estimate to AUD 4.15 from AUD 4.45, with narrow-moat Stockland screening as undervalued, currently trading around AUD 3.60.

Following cuts to residential sales and margins, we now forecast growth in fiscal 2019 funds from operations, or FFO, of 4.5%, just below the recently reiterated guidance for growth of 5%-7%. Over the medium term, Stockland should benefit from its recently implemented strategy to sell more complete townhouses rather than vacant lots. Finished houses generate higher profit per lot, but profit margins are lower due to the significantly higher price point for completed dwelling compared with a vacant low. Stockland’s focus on completed houses is a positive differentiator as it takes a few months from putting down a deposit to moving in to a new house. This is vastly superior to the standard city fringe lot sale in Australia, where the buyers put down a deposit for a lot, then it takes a further two years to add services and build a house.

Sales for Stockland’s retail shopping centre portfolio remain lacklustre with total centre comparable sales up just 1.8% and the high rent-paying specialty retailers achieving comparable sales growth of 1.5% for the year ending September. It is worth noting the comparable basket excludes centres that have been redeveloped within the past two years, such as Green Hills in Maitland, New South Wales. When Stockland includes the recently rejuvenated assets in the comparable metrics, total sales were up 4.2% and specialty sales were up 6.4%.

All up, the sales metrics imply malls that have not recently undergone redevelopment work are performing weakly. This is disconcerting as Australian household spending currently has very strong support from a very low unemployment rate, stimulatory fiscal policies and ultra-low mortgage rates. In time these microeconomic tailwinds will eventually abate, exposing tenants to far more conservative household spending. Due to this plus an expectation of further retail sales occurring online we forecast total rent growth across the portfolio will remain weak for the foreseeable future. In this regard we forecast retail rent growth (combination of specialties and anchor tenants) will grow at a compound average rate 2.15% over the next decade. Most specialty leases contain fixed rental increases of between 4%-5%, but this isn’t sustainable without commensurate growth in sales as tenant margins will be gradually eroded if rents are growing faster than sales. When the next period of economic contraction comes around, we anticipate tenants are likely to negotiate rental reductions. It’s impossible to say when this will occur, but we believe we have captured this risk in our long-term rental growth assumptions.

The other challenge for Stockland and other retail landlords is determining how to remix their malls to make them more resilient to fast evolving consumer spending patterns. All consumers--but especially those under 40--have been increasing the percentage of product purchased via digital channels. The categories that are suffering the most from this are apparel and cosmetics; both traditionally high rent paying categories that make up a material component of the mall trading area. Stockland (and all peers) have responded to this by reducing the footprint allocated to weaker categories and installing more contemporary tenancies such as medical services (opticians, beauty clinics, massage) or adding food retailers. The fact that comparable sales for food catering was up only 1.8% over the past year indicates there is reduced scope to allocate more space to food catering without cannibalising existing tenancies. At this juncture we don’t have an up-and-coming retail category to compensate for challenges faced by many legacy retailers.