Investment View
An overall respectable 1H23 result albeit propped up by trading profits. The outlook for FY23 is in a strong position with occupancies expected to improve and development expected to continue to progress.
Balance sheet is robust, displaying no reason for caution. Hedging (85%) is at the higher end of the sector and the gearing (26%) is middle of the range for the sector. Divestments continue to be a key area of focus as they will contribute to funding the development pipeline.
We don’t expect a large cap rate cycle in valuations. A-REITs cap rate expansion at 1H23 was extremely minor (~0.08%). There remains a large disconnect between caps rates and the move in risk free rates over the last 18 months. The gap can partially be explained by a lack of physical property transactions, particularly in prime office buildings.
Improvement of physical office occupancy is underway. Europe and the Middle East are seeing physical attendance return to 70-90% of pre-COVID levels with the US lagging (but improving) at just 40-60% (WSJ & JLL). Australian data suggests that CBD occupancy is continuing to improve, up ~10% since the Sept 22 quarter, but still below pre-COVID levels.
Dexus is trading at a discount to its long-term average Price / Funds from Operations (P/FFO). At a 2 standard deviation discount to its long-term P/FFO and a ~35% discount to book value. DXS is the cheapest of the S&P/ASX 100 REITs on a price to book value.
Sector M&A remains a real possibility given depressed valuations. Global interest in the Australian office operators continues. Blackstone has raised private capital which is looking for deployment. We have seen private capital buy Australian listed assets in the past, Morgan Stanley Real Estate Fund for Investa Property Group (2015), Blackstone Group for Valad Property Group (2011), Frasers for Australand (2014).
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 being given to the funds management business in the current price, which should account for ~15% of valuation in this environment. We maintain our HOLD rating on Dexus.
Cornerstone Questions
1. ARE PEOPLE GETTING BACK IN THE OFFICE?
The structural headwind from the increase of WFH remains, with a hybrid work model where individuals split workdays between home and office seeming now built into cultural practices. Globally, trends suggest that people are making their way back into offices.
We take Europe and the Middle East’s occupancy recovery as a leading indicator for the global environment. Whilst Australia and the US are still lagging behind, the trend remains positive with a significant improvement seen since Q3 CY22.
Data from the Property Council of Australia indicates that Australian CBD office occupancy has continued to improve post-pandemic (January is seasonally lower than other periods due to the holiday calendar). We will continue to closely monitor occupancy data over the next 12 months to assess the level of structural impacts of office occupancy from COVID.
FIGURE 1: AUSTRALIAN OFFICE PHYSICAL PROPERY OCCUPANCY IMPROVEMENT
2. ARE VALUATION CAP RATES GOING TO RISE BY >1% THIS CYCLE?
Short answer, No.
Whilst in prior cycles cap rates expanded ~2% (GFC), we don’t believe this will be repeated this cycle as the A-REITS aren’t as heavily leveraged and we are unlikely to see a repeat of the forced asset sales that happened in GFC, and in the early 1990s.
We expect cap rates will see minor expansions (0.3% to 0.5%) over the next 6 months. Capital positions remain strong for the Australian office operators, and we expect that A grade and premium asset valuations will be relatively defensive in this cycle (86% of Dexus’ portfolio).
The market is closely watching for any transactions that would indicate a devaluation of Australian office assets. Transaction activity remains weak in commercial office markets. The pending sale of 717 Bourke Street in Melbourne (17 storey A-grade office near Melbourne Docklands) remains a focus point for the office market. The building is currently on its third sales attempt in recent times.
For every 15% decrease in asset values (DXS NTA), the gearing of DXS increases by ~5%. Balance sheet gearing is currently 26%.
3. WHAT WILL DRIVE A VALUATION RE-RATE IN DXS SHARE PRICE?
The market is looking for clear signals that the operating environment is improving. The core aspects that will drive a re-rate are:
a. Clear and significant improvements in the Australian physical office occupancy
b. Indications that cap rates are expanding to the level that the share price has priced in. Data to come from market transactions and portfolio releases later in the year.
c. Peaking of interest rates and changing central bank policy
d. Opportunities for M&A. Potential interest from international funds/consortiums.
Risks to Investment View
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. The prospect of valuation and occupancy headwinds in our view will likely remain the key focus of investors over the next 12-24 months.
Current multiples do provide an attractive offer with the Price to Funds from Operations (P/FFO) ~2 standard deviations below the long-term average and the Price to book value at a ~35% discount. Despite this, we remain diligent in avoiding changing our thesis purely on a depressed multiple and will focus on changing transaction and operating conditions to be a driver for a change in view.
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.
We maintain our HOLD rating on Dexus.
Figure 1: DEXUS P/FFO trading at a ~2 standard deviation discount to long term average.
Figure 2: P/BV remains at a ~35% discount. Yet to see any recovery to pre-pandemic levels.
