Result Overview
Region came out with its 1H23 result this morning. Very few surprises given DPS, and asset valuations were pre-announced.
Operating conditions appear to remain robust with net operating income (NOI) continuing to increase at 4.2%. Leasing spreads are 4.4%, up from 3.3% 2H22 but are likely a product of Covid normalisation. Annual rent increases of 3.9% unable to capture the full impact of inflationary benefits on ~88% of specialty stores
Balance sheet remains in a strong position, gearing at the low end of target range and hedging is well poised for higher interest rates.
Headline Result:
- Statutory net loss after tax of A$95.1m driven by property portfolio devaluing from cap rate expansion.
- Adjusted Funds from Operation per share (AFFOps) at 7.60cps in-line with consensus. DPS pre-announced (7.5cps).
- Balance sheet gearing is at 31.7% (32.2% look through), lower end of 30-40% target range.
- NTA per share is A$2.65, down 5.7%, implying the share price is trading at a premium to NTA.
Guidance:
- Bank Bill Swap Rates (BBSW) for 2H23 at 3.6% (previously 3.35%)
- Small upgrade to FY23 AFFO at 15.2cps (15cps prev) with a target payout of ~100%.
The company is trading at parity to book value (AREITs all trading at an average ~16% discount) and has the second lowest 3yr forward FFO CAGR at -0.8%. We are unlikely to see a significant change in the earnings trajectory in the short term and believe the market will focus on the heavily discounted higher growth REITs.
Given the stock trades at a small premium to NTA and the earnings growth outlook is flat, we re-iterate our Hold rating. The group is performing well operationally, but the overarching theme of cap rate expansion and rising interest rate costs is likely to suppress the short-term performance.
Operations
Sub-regional and neighbourhood centres are seeing an improvement to operations post pandemic and will likely continue to trend upwards as conditions continue to normalise. 1H23 with comparable net operating income (NOI) grew at 4.2%.
Funds from Operation (FFO) was flat (-0.2%) yoy at A$94.1m due to higher cost of debt and AFFOps increased +5.9% to A$85.7m due to the 4.2% growth in NOI. The DPS of 7.5cps was pre-announced, represents a 99% payout ratio.
Over 1H23, RGN renegotiated 198 leases at an average leasing spread of 4.4%, an increase from 3.3% in 2H22 and 2.4% for full year FY22. This is likely testament to a recovery post-pandemic and less so a core improvement in operations, so we’d expect this growth to fade in 2H23.
Divestments of Carrara (QLD) shopping centre at a 2.2% premium to book value will be used to better the balance sheet position in the short term and will be deployed when necessary to further acquisitions. Similarly, RGN sold down its remaining stake in the Charter Hall retail REIT (CQR) as it was a non-core asset with no operational benefit, and the capital would be more useful on the balance sheet in the short term.
RGN’s Metro Fund JV with GIC saw no further increases to Assets under management (AUM) due to a disconnect between purchasers and sellers on pricing expectations. Only a handful of deals have been done industry wide given increasing cost of capital and vendor price expectations.
The group looks to be progressing well albeit growing earnings below the rate of inflation. The earnings base remains defensive and is expected to continue to grow within the Group’s target range of 2-4% pa given the non-discretionary rent-based model. The earnings benefit from the capital light model is continuing to ramp up but given no further growth in assets its unlikely to be a game changer for the multiple.
Rising Cap Rates Decreasing the Portfolio Valuation
The statutory loss of A$95.1m is unsurprising given RGN’s December announcement already flagged that weighted average cap rates (WACR) had increased 0.23% (5.44% to 5.67%), representing a ~3% decline in asset valuations. RGN is roughly halfway through the company’s expectation for cap rate expansion (0.23% out of 0.50% expected)
Declining asset valuations is not unique for RGN and is likely to be seen throughout the AREIT sector. Notably the sector is trading at an average ~16% discount to NTA on expectations for increasing cap rates. RGN’s lack of a discount to book value makes it less desirable vs peers and may drive some downside pressure on the share price as the book value is likely to fall in 2H23 with lower cap rates.
Figure 1: AREIT discount to NTA. Market pricing in impacts from cap rate expansion on asset valuations.
Balance Sheet
1. Gearing
The balance sheet remains in a strong position despite expanding cap rates and increasing interest expenses. RGN is taking a conservative and well-disciplined approach to balance sheet operations with gearing at ~31.7%. This is expected to fall lower to ~28% post-Dividend Reinvestment Plan (DRP), Carrara (QLD) asset sale and sell down of remaining Charter Hall REIT (CQR) stake, well below the target range of 30-40%.
Management currently believes there is no rush to push gearing back above 30% and expects it will happen later in the year through acquisitions of regional centres that come under pressure from increasing cost of funding as well as cap rates as each +0.25% increase equates to a 1.5% increase in gearing.
Figure 2: Gearing historically has remained around the lower end of the 30-40% target range.
2. Debt & Interest Rate Hedging
Interest rate hedging remains in a strong position for the rate hike cycle. Fixed and hedged debt increased from 69.6% to 76.5% over 1H23 and is guided to increase to ~82% for FY23, towards the upper end of the company's target range of 50%-100%. FY24 hedged debt is guided to be ~71%, which includes the A$255m Medium Term Note (MTN) in June which will be drawn from cash.
RGN has no debt expiries until June 2024 with management indicating that they will remain in talks with the banks to push debt repayments further back. The average cost of debt for the half is 3.2% (up from 2.4% 1H22) and will continue to put pressure on the cost line as rates increase.
Figure 3: Hedging profile for RGN. FY23 and FY23 in strong position to weather rate hike cycle.
Earnings Expectations
Region has been one of the more defensive AREITs over the past 12 months, outperforming the AREIT index by ~7%.
Anticipated cap rate expansion of ~0.27% will continue to lower the NTA value. Given the limited potential for earnings growth within the rent model, we expect the share price to trade at or around NTA in the 2H 2023.
Figure 4: RGN offers a 3yr fwd FFO CAGR of -0.8% (2nd lowest in the sector) and no discount to book value
Risks to Investment View
Investment Thesis
We re-iterate our Hold rating for RGN as the pressures from expanding cap rates are likely to continue to be felt throughout 2H23. The share price premium to NTA, coupled with flat earnings growth suggests that the market is unlikely to get excited unless an accretive M&A transaction can be secured.
RGN previously was a hostage to bond yields (as mentioned in our last note) and now is a captive to cap rates. The earnings model offers little benefit over the short term and, whilst defensive, has been unable to drive multiple expansion in current market conditions.
We avoid getting more negative as we believe bond yield in Australia have largely peaked.
A potential catalyst we are watching is the progress of acquisitions in the capital light Metro fund. As it currently stands, we prefer REITs which have clearer growth paths and are trading on a discount to book value.
Figure 1: P/FFO
Figure 2: P/NTA
Figure 3: ROE
Figure 4: DIV YIELD
