Re-landscaping the REIT sector
The year 2017 unexpectedly marked the end of Westfield – at least in relation to the corporate entity that carries the name of well-known shopping centres. On December 7th investors in Westfield Corporation (WFD) received a proposal to merge with the Dutch origin property giant, Unibail Rodamco (‘Unibail’). The deal was consummated by an in-principal acceptance by the Lowy family and directors which valued the company at $33 billion, a 32% premium to the prevailing share price. If the deal meets all regulatory hurdles and shareholder approvals, it will represent the largest corporate merger in Australia’s history.
Unibail itself has an illustrious history as a company. It was formed in 1968, initially as a finance leasing company before winding down this business in the 1990s to establish itself as a commercial property operator. In 2007 the company merged with Rodamco Europe to form a large regional player in European property, representing approximately 16% of the EPRA/NAREIT Developed European Index. The merger makes strategic sense, considering the complementarity of the respective Westfield and Unibail asset portfolios. Unibail’s footprint consists primarily of 71 shopping centres across the region together with 13 office buildings and 10 convention centres in Paris and surrounding areas. Retail property accounts for about 85% of its portfolio.
If the deal meets all regulatory hurdles and shareholder approvals, it will represent the largest corporate merger in Australia’s history.
Westfield’s offshore asset base consists of large shopping centres in the US and the UK, along with development opportunities for new and existing centres, as well as residential apartments. Bringing these entities together will result in a largely retail property behemoth representing US$72 billion (A$96 billion) of assets.
The deal is unlikely to face any material resistance. Westfield’s shareholders will be furnished with independent valuation reports prior to voting on the proposal and can be expected to support the combined scrip and cash offer. There remains a chance that another party could show its hand and conduct a raid on the register, although we see this as a relatively low probability event. The sheer size of the transaction limits the potential bidders to a small handful of property companies with the requisite balance sheet strength. This list of potentials would realistically be limited to the largest US REIT and sovereign wealth funds. With all hurdles being met, the merger should be completed by mid-2018.
The choice for shareholders
The next question on the minds of existing Westfield shareholders is whether their Australian-listed holding will be subsumed into an offshore listing. Under the terms of the offer, existing shareholders will receive around 35% of the value as US$2.67 in cash for each Westfield share held together with the option of receiving the remainder as Unibail Netherlands-listed stock or Chess Depository Interests (CDIs) which will be tradeable on the ASX. It is likely that the majority of Australian domiciled investors would opt for the latter and retain exposure to the enlarged entity. Existing shareholders may hold some concerns over the value of the deal, given that Westfield’s share price has remained below its post-announcement level. However, this is largely a reflection of US dollar weakness and the translation of value for its underlying assets rather than a concern over the deal’s intrinsic value.
Despite the loss of an iconic name and major component of the Australian REIT Index, the sale is a net positive for investors as it will reduce the size of the retail sector and improve diversification. Westfield’s representation within the Index under the combined CDI security will fall from around 15% to 5% and the retail sector will fall from 44% to 35%. There is also likely to be some re-weighting into office, industrial and logistics assets from proceeds of the sale. The aggregate cash component is the equivalent of about two years’ worth of capital raisings across the sector, so we’re likely to see a bolstering of capital accounts within the majors like Stockland, Dexus, GPT and Goodman Group.
The aggregate cash component is the equivalent of about two years’ worth of capital raisings across the sector
REIT opportunities abound
Beyond Westfield and the other major REITs there are a number of good opportunities in new segments such as childcare, retirement living and storage. Demand for such assets in Australia is growing along with the well-publicised shortages of child care and accommodation needs associated with demographic shifts. Supply of these assets remains short and the release of Westfield capital will benefit these areas of the market.
Storage is another area with growing demand credentials. This sector’s growth is being driven by issues like cybersecurity and shifts to cloud data storage. An example of operators in this space is Iron Mountain. Our fund recently invested in the company, which provides a range of data storage and document management services. The operational leverage of companies like this is substantial, with limited incremental capital spend required to expand capacity. In simple terms, the company is able to lease out eight cubic metres of lettable space for each single square metre of floor space. Fundamentally, success in property investment is a function of acquiring quality assets and generating productivity and operational efficiency. Iron Mountain clearly fits those criteria.
Investors may look at Barangaroo and associate these mega towers with compensating supply, but over 90% of the three towers is already leased.
The office sector represents another area of interest. Office space in Sydney and Melbourne – the vast majority of index exposure – is operating at supply-constrained levels not seen for many years. Take a close look at Sydney’s CBD and you see a considerable loss of office space, courtesy of some large office buildings being torn down in Martin Place and Hunter Street to make way for the Metro and alternate uses. Investors may look at Barangaroo and associate these mega towers with compensating supply, but over 90% of the three towers is already leased.
Property managers have been reporting buoyant conditions on the leasing side, to the extent that tenant incentives typically associated with long term leases like rent-free periods and fit-out contributions are no longer being offered to entice new tenants. Melbourne’s CBD office space is showing similar space constraints, reflecting a combination of both gains in white collar employment and centralisation of businesses from suburban markets to the CBD. Vacancy rates in the CBD have fallen to close to 6%. Melbourne is seeing a boom in construction activity and while this will ease supply constraints, the lead time to completions is significant. A similar dynamic applies to the Sydney office market.
Value across the REIT sector
The property securities sector has been exposed to the headwinds of interest rate markets, with the US having passed three rate rises since it began the tightening cycle. Further unwinding of monetary stimulus is likely in the US, followed by Europe at a later stage, which casts a shadow over the sector’s relative valuation metrics. Inflation expectations are also starting to reflect in valuations, while a soft domestic retail sector reflects the impacts of household leverage and stagnant wages growth. These amount to notable risks for the sector, but pricing dynamics within the sector sound a more positive tone. In the private markets for direct property, recent transactions have been completed at cap rates – a measure of prospective cash flow yield for the capital outlaid – close to 4%. Cap rates in private markets should translate to support for valuations in public markets.
The Westfield merger is part of a broader global thematic that reflects strong appetite to acquire public market assets. UK-listed property company, Hammerson, launched a bid in December for a smaller UK property rival, Intu, at a 28% premium to its prevailing share price. In the US there will be potential corporate activity in other large mall owners – Taubman, General Growth and Macerich – with activist shareholders on their registers. The operators of large property portfolios are clearly keeping bond market movements in perspective and see longer term value in prime property assets. These dynamics suggest that opportunities for investors are significant, both within and beyond the big names.