Dexus Property (DXS) is Australia’s largest office property landlord with 55% assets concentrated around the Sydney CBD/fringe. Whilst the group is reallocating capital away from office assets, the health of Sydney office property market remains the key influence on the DXS share price. 85-90% of income is derived from rental income.
DXS is a high-quality, active real estate manager. The Group is looking to actively improve its portfolio and return profile via asset disposals and reinvesting into its development pipeline and funds management business.
Prime A-grade office assets which dominate DXS portfolio require significant amounts of capital to build and have relatively illiquid secondary markets. Investors need to be aware that in difficult markets (rates rising unemployment, corporate defaults) office assets tend to gap down resulting in distressed pricing.
Building funds management exposure. DXS has actively lifted its exposure to external AUM from ~A$15bn to $25bn over the last 4 years. DXS is looking to further increase AUM by acquiring Collimate Capital, AMP’s Real Estate funds management and domestic infrastructure arm for A$275m. Collimate has A$17.5bn of AUM split 45% property and 55% infrastructure.
Discount to book value. DXS last traded at a >30% discount to book value was in the depths of the GFC when a liquidity crisis engulfed the office sector. This resulted in forced selling, recapitalisation of balance sheets. Office cap rates expanded by ~2.0% points.
Today, the equity market is fearful that higher bond yields will push up cap rates and that work from home (WFH) trends will lower office demand for office space permanently. Interest rate costs are high (rather than debt margins) and have risen ~3.0% in >12-months. So far there is no evidence of A-grade property assets seeing expansion in cap rates, whilst vacancy rates/rental incentives have remained largely flat. We expect office cap rates to rise ~1.50% in this cycle.
Investment view We rate DXS a Hold. The current share price significantly captures a large deterioration in the office market outlook and the likely hit to earnings for DXS.
We also believe there is little valuation attribution given to the funds management business in the share price, which should account for ~15% of valuation in this environment.
A more positive stance on DXS needs to see a peaking of inflation expectations/bond yields and line of sight on DXS funding profile.
Business Overview
Dexus’ operations are split into two segments currently split 85/15 from an earnings contribution perspective.
Firstly, the group develops and operates assets held on the balance sheet. The balance sheet consists predominantly of office assets (72%) and industrial assets (23%). The group typically recycles around A$1bn of offices per year within the portfolio.
The second segment is the Funds Management business. This consists of exposures across the office (41%), industrial (28%), retail (23%) as well as healthcare and other REITs.
The Funds platform investor base is heavily driven by offshore investors with ~50% being superannuation and pension fund asset. Over the past 10 years, the Funds Management platform has reduced its exposure of retail assets from ~50% down to ~23%, with office and industrial asset exposure lifting.
Strategic Direction
Dexus’ culture is opportunistic regarding property income. The Group earns ~ A$40m pa from trading properties.
In recent years, the DXS has pushed into infrastructure and industrial assets – the largest being the ~$1.5bn industrial airport precinct at Jandakot (Perth, WA). Infrastructure is a more recent addition reflective of the ultimately of the capped size of the capital city office market.
Dexus has been making a push to lift earnings from the Funds Management segment of the business. The strategy is expected to be supercharged through the proposed purchase of AMP’s Collimate Capital, which will lift the portfolio value by A$17.5bn (a ~68% increase to FY22 FUM).
FUM-based earnings are the fastest-growing area of DXS and provide the Group with a capital-light income stream relative to owning assets on the balance sheet. It also facilitates the ability to recycle capital at a faster rate by selling mature assets into the Funds business.
The Collimate portfolio will be the second major capital deployment directed into industrial/infrastructure assets. The portfolio includes assets like Macarthur Wind Farm (VIC) and Perth Stadium (WA) will further shift the group’s strategy away from being a pure-play property management company.
Ultimately, we see the office as being the prime focus of DXS. The market still considers DXS as an office specialist, rather than looking to evolve into a diversified REIT like GPT Group (GPT).
Figure 1: Funds management income vs property income. Collimate acquisition is expected to lift FUM from A$25.9bn to A$43.4bn.
Work from home forever?
The key debate in the office REIT sector post-COVID is whether workers return to CBD offices. CBD offices in Sydney and Melbourne are operating at ~50% occupancy (September 2022), whilst the vacancy rates in Sydney have doubled to 12%, and in Melbourne to 14% since 2019.
Whether WFH becomes a permanent (or structural) feature of office markets is a highly emotive issue. What we can observe at present, in one of the tightest labour markets for decades, is that workers and employers are facilitating the acceptance of hybrid workplaces (a mixture of both office and home).
CBD’s like Brisbane and Perth, which had a lower number of COVID lockdown days only have occupancy rates of ~57% and 70% respectively (well below pre-COVID levels).
Now whether WFH trends are durable through a potentially softer labour market remains a key question. As does the question of whether corporates continue to ‘hoard’ office space despite low levels of utilisation.
The debate around WFH is closely tied to new office supply. In Sydney, new supply is expected to add ~8% to floor space by 2025/26 through key office projects like Lendlease’s Salesforce Tower at Circular Quay, and Macquarie/Investa Martin Place development, Atlassian Central project, Central Place development and Pitt/Bridge Precinct.
Melbourne’s new office supply is estimated to add ~9% space growth by 2025/26. Amazon is taking one of two towers on Collins Street being developed by Charter Hall (CHC).
Sandstone Insights View: Both Centuria Office REIT (COF) and DXS have reported September quarter updates which suggested that office market conditions have stabilised from both a vacancy and a rental incentives perspective in the quarter.
It remains too early to suggest that office markets have troughed, considering excessively tight labour markets (potential to weaken in 2023) and pending new office supply. We remain concerned that employers are hoarding space, whilst cap rates have yet to adjust. DXS reported a 10bps contraction in the 6 months to June 2022.
Performance of office REITs
Globally, office REITs have been the worst-performing sub-sector within the REIT sector this year. Higher bond yields and fears around the potential structural decline in office demand have weighed on the sector.
The DXS share price closely tracks the S&P US office REIT Index (US$65bn market capitalisation) which has 17 REITs within the index.
The US office REIT index is dominated by Alexandria Real Estate Equities (ARE.US, market cap USD$24bn), which has a focus on healthcare workplaces and has significantly underperformed (-29%) the S&P500 index over the last 12 months which is down -19% over the last 12 months.
Investors are giving office REITs a wide berth at present in the face of; 1) higher bond yields; 2) central bank efforts to calm inflation (by lifting unemployment, potentially lowering occupancy) and 3) the debate on the work-from-home thematic.
In our view, for DXS share price to improve, one or more of these issues needs to be resolved in the eyes of investors.
FIGURE 2: DXS share price is highly correlated the performance of us office REITs index*
Headwind of Rising Bonds yields
The DXS share price has underperformed the S&P/ASX 200 in 4/7 last periods of rising 10-year bond yields since 2006.
The large underperformance of DXS in the current period (bottom quartile of A-REIT index members over the last 12 months) is a combination of both rising bond yields and the debate around work-from-home trends weighing the DXS share price.
A peaking of long bond yields typically marks the end of the underperformance of DXS share price versus the market. The post-GFC period of underperformance in 2010/11, DXS saw the share price bottom at 0.7x price to NTA. DXS currently trades at 0.6x NTA.
Figure 3: DXS vs S&P/ASX 200 relative share performance in periods of rising bond yields.
Office CAP RATES
Like other areas of the property sector, office assets post-GFC have benefited from the compression of cap rates lifting asset values. For DXS, cap rates have fallen from 7.7% (2011) to 4.5% with DXS prime A-grade assets benefiting significantly from the compression of cap rates.
When combined with generally full occupancy levels across the portfolio, asset values have never been higher. Occupancy levels were 98% pre-COVID, currently, occupancy stands at 96%.
This backdrop makes the valuation debate for DXS the key investor issue going into 2023. The last time bond yields were at >4.0%, office cap rates were at +7%. The most recent valuation (30 June 2022) of DXS’s office assets had a 0.10% compression in cap rates.
With little evidence of transaction values falling in response to current market conditions – cap rates, high incentives, and low utilisation of office assets despite high occupancy rates, property valuers at this point don’t have the evidence to increase cap rates and lower valuations.
Public investors have already voted. DXS share price has fallen ~35% through 2022 (the worst performing large cap REITs) with the share price trading at 40% discount to NTA (30 June 2022 valuation).
Figure 4: DXS trades at largest discount to net assets within the REIT sector.
Whilst a ~40% discount to book value sounds enticing, a potential reversion in valuation cap rates could significantly close the apparent valuation gap for DXS. Particularly if combined with a reduction in office income levels (lower passing rents + higher vacancy rates).
Valuation scenarios
We estimate the DXS share price is currently implying a rise in cap rates to 7.3% (2014 levels) vs current cap rates of 4.5%.
A bear case scenario of cap rates rising to +7.3% and income levels dropping ~15%, implies a market cap A$6.5bn or a share price ~20% lower than the current share price.
Figure 5: DXS valuation scenarios. Current share price is implying 2011 office cap rates of +7.3%
Just where cap rates and office vacancy rates move is highly uncertain at this point of the cycle. Directionally, it is only a matter of time before cap rates begin rising given higher bond yields.
Cap rates in the last cycle had the impact of higher bond yields. But the true peak in cap rates was not until 2011 when the office market was saturated with supply coupled with lower occupancy rates and lower income levels.
The other key feature of the last cycle in office cap rates was the credit crunch. This impacted both REITs and tenants who had over-extended financial leverage resulting in liquidity issues, forced selling, and recapitalisation of balance sheets. This was exacerbated by several features of the cycle; 1) excess supply of office buildings; 2) excess demand from tenants; and 3) a large number of layoffs.
There is a reasonable argument in this cycle, that tenants don’t let go of their office space as employment remains strong and firms hoard office space for fear of missing out when the cycle turns. This also plays into the WFH dynamic, where employers are not certain just how much of the workforce returns to the office for a traditional 5-day week.
New Capital Developments
DXS has a committed capital development pipeline of A$3bn across FY23-F26E. New projects include the Atlassian Central Project (Office, NSW), Jandakot Airport (Industrial, WA), Australian Bragg Centre (Healthcare, SA), Ravenhall (Industrial, VIC) and 123 Albert Street (Office, QLD).
To fund developments DXS typically recycles ~$1bn of assets per year by selling assets and recycling them into new developments. So far in FY23E, DXS has sold ~A$900m of assets.
In our view, DXS will look to recycle a further $1.0-1.5bn assets over the coming 12-18mths to ensure adequate balance sheet liquidity to fund these developments. In addition, DXS is looking to sell down partial ownership stakes in several of its new developments.
Only a significant dislocation in property and financial markets over a >12-month period would leave DXS’s balance sheet with a funding hole to execute these new developments, which would require an equity raising.
Balance Sheet
Balance sheet gearing currently stands at 27.8% (target range 30-40%), around the mid-point of the sector. Despite the current gearing being below the Board’s targeted position, gearing levels could come under pressure if cap rates rise and assets devalue.
A ~1% lift in the cap rates would lead to asset valuations compressing ~20%, which in turn would lift the balance sheet gearing to ~34%.
Gearing could lift into the mid-40 % if you include DXS’s committed development pipeline across new/redeveloped properties. DXS can fund a potential capital shortfall by selling assets with proceeds being applied to the debt. We estimate that DXS would need to sell a further ~$1.5bn of assets to hold gearing at 35% if property valuations fell 20%. This is in addition to the ~$1bn of assets sold in the current period.
DXS is 65% hedged for FY22E down from 81% FY21 with an average hedge maturity of 5.9 years. This is at the lower end of the sector hedging and presents a headwind to FFO growth if bond yields remain elevated over the medium term (particularly in combination with softer rental income). Rental yield growth remains in a fine position with average fixed rent increases of 3.5-4%.
Until late October 2022, DXS had an on-market share buy-back program in place to buy up to 3% of shares on issue. DXS did not utilise the buy-back program. DXS has had a mixed track record with buybacks. In 2018 DXS on-market buy-back purchased just 0.2% of shares on issue before being paused, with equity capital raising in 2019.
We don’t believe the Board will restart the buy-back in the current environment, particularly with the DXS development pipeline and capital requirements.
Figure 6: DXS balance sheet Capital allocation over the past 3 years.
CEO tenure
DXS CEO Darren Steinberg has been in the role since 2012 and is now the longest-serving CEO in the REIT sector. Darren is on an open-ended employment contract.
By the middle of 2023, half the CEOs across the REIT sector will have been in the role for less than 3 years. An unusually high number of relatively fresh faces across the sector. The management teams that lead many of the REITs over the last decade of low-interest rates are now changing.
We would not be surprised to see another round of M&A within the sector. With the sector trading at ~25% discount to book value (ex Charter Hall Group (CHC) and Goodman Group (GMG) and new management teams place – there will be inherent pressure to close the valuation gap.
Whether the Board of DXS (or Darren himself) decide that change is needed is an interesting debate. Portfolios of A-grade office assets have strong investor appeal to both local and offshore investors. We note the takeover of Investa Property Group in 2014 by global investors Morgan Stanley Real Estate which at the time was second only to DXS in terms of size in Australian office markets. With both DXS and COF trading at a 30-40% to-book value, the pressure to close the valuation will only build over time.
Figure 7: Forecast A-REIT CEO tenure as at 30 June 2023
Risks to investment view
Upside risks
- Unused share buyback is activated
- Office markets show faster than expected improvements across vacancy and return to rental growth
- Successful divestment of A$1bn of asset sales, leading to accelerated capital recycling
- Stronger than expected development returns
- Office market fundamentals improve, particularly in Sydney where the vacancy rate is double the pre-covid levels
Downside risks
- Property cap rate expansion in response to rising bond yields lowers property valuations
- Continued loss of AMP FUM
- Refinancing of $1.3bn of debt facilities in FY24
- Office markets deterioration or work from home remains popular.
- Large FUM losses from the recently acquired Collimate Capital (AMP) business
- Economic downturn
Investment Thesis
The outlook for the Australian office markets continues to look challenging, with elevated office vacancy levels and the prospects of falling office asset prices. Discount rates (or cap rates) used for office valuations are at cycle lows, whilst the RBA cash rate has risen ~3.0% in 2022. The prospect of valuation and occupancy headwinds in our view is likely to remain a key focus of investors over the next 12-24 months.
DXS’s overweight exposure to the Sydney office market is expected to see rising levels of net-new prime-grade office space into FY25E. Office vacancy rates are likely to remain above the long-term average over the next 12-24 months.
We see downside risks to DXS dividend forecasts over FY23-24E.
The DXS’s share price currently trades at a 30-40% discount to net asset value. We see few company-specific catalysts to close the gap near-term. DXS is selling office assets at a discount to book value, whilst reinvesting the proceeds into other office and industrial assets. The balance sheet does not have sufficient headroom to consider capital management ahead of its large office developments in Sydney.
We rate DXS a Hold. The current share price significantly captures a large deterioration in the office market outlook and a potential hit to earnings for DXS. We believe there is little valuation attribution is being given to the funds management business in the current price, which should account for ~15% of valuation in this environment. A more positive stance on DXS needs to be accompanied by the peaking of inflation expectations and bond yields.
Figure 8: DXS falling return on equity underpins the importance of funds strategy
Figure 9: DXS price to book now below GFC levels of 0.7x
Figure 10: Dividend yield now >6.5%, the highest in the REIT sector
Figure 11: DXS dividend yield vs AU 10yr bond.
