We recently researched Dexus (ASX:DXS) in The Dynamic Investor to assess whether the shares present any value. Negative sentiment towards global office exposed REITs has resulted in large discounts to Net Tangible Assets (NTA) in both the Australian market and the global market.
With this in mind, we assess whether DXS’ key metrics and recent change in strategy can bridge DXS’ currently large discount to NTA.
Overview of Dexus
Dexus is an internally-managed ASX-listed stapled REIT that owns, manages and develops real estate in Australia. The Company’s operations are focusing principally in the Office (of which ¬95% is classified as ‘Prime Grade’ office space) and Industrial sectors.
The business strategy revolves around leveraging off two key long-term growth themes. The first of increased urbanisation in and around key economic and transport hubs. The second is increased demand for real assets consistent with growth in pension capital flows.
Dexus currently manages $44b of external Assets Under management (AUM) across real estate and infrastructure and intends to pivot towards a funds management/development strategy spanning real estate/real assets/infrastructure.
Key Fundamental Drivers
High Occupancy Rates Maintained as Flight-To-Quality Persists
For the six months to 31 December 2022 (1H23), DXS reported office occupancy of 95.3%, which was a slight decline from the prior half-year period. The Company noting at the time of the 1H23 results release that economic conditions weighed on demand, thus increasing the time to convert leases. Office occupancy as at 31 March 2023 (3Q23) was stable, at 95.4% and well ahead of the market at 88%. Occupancy for the industrial portfolio (which accounts for ~24% of the overall $17.8b portfolio by value) improved to 97.8%, from 97.4% as at 1H23.
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As DXS’ office portfolio is 95% prime grade, it is outperforming the general office market. The Company is benefitting from a flight to quality, with well-located higher-quality buildings attracting stronger demand. Net absorption for prime grade stock has materially outperformed secondary stock for the past eight quarters (according to JLL). DXS also noted that leasing and enquiry levels for Prime grade properties remains strong. These trends are resulting in +95% occupancy rates for DXS.
In addition, physical occupancy has been increasing in the key Sydney and Melbourne office markets, towards pre-COVID levels (50-65% on a portfolio level as at 1H23). The Company has previously highlighted that there is latent demand due to the significant amount of labour growth experienced over the past two years, with larger tenants beginning to look for space this calendar year.
While DXS is outperforming the broader market in office occupancy, vacancy rates for prime assets remain relatively high. There are two reasons for this. Firstly, the continued increase of stock due to projects that are already underway are being met with muted demand. Secondly, there are higher levels of sub-leases.
Office Incentives Remain Elevated
Face rent remains relatively stable and high. Despite this, the impact of incentives and negative leasing spreads are resulting in more muted underlying effective rent. (Face rent is a rental figure that disregards incentives such as rent-free periods, rent reductions (i.e rent abatements) and fit-out contributions.)
Incentives have been steadily rising over the years despite improving fundamentals from employees returning to office. The current level of incentives is expected to remain high over the short to medium term. This is because there is additional supply coming online. There is also difficulty in converting leasing deals, as tenants were becoming cautious of business conditions. These factors are resulting in continued pressure on effective rental growth.
Gearing at Risk of Edging Higher
As at 31 December 2022, DXS had gearing of 25.6% which compares to a target range of 30-40%. Should DXS complete its committed development pipeline, gearing could rise to ~34%. An estimated 6% decline in the valuation of DXS’ portfolio for the six months to 30 June 2023 is likely to increase the gearing levels even further, however DXS has until 2028 when developments complete to obtain appropriate funding. As such, should devaluations occur, for a group with a track record of capital recycling, there is time on DXS’ side.
Change in Strategy May Provide Valuation Support
Office asset valuations remain under pressure. However, the Company has a stated strategy of reducing capital heavy (i.e. 100% owned) balance sheet assets. This strategy involves shifting to a capital light model. Under this model, the balance sheet would consist of cornerstone stakes in core real estate/infrastructure funds, warehoused assets (to seed new funds) and development inventory.
In particular, DXS is aiming for active sources to comprise 20% of total income from ~11% at present. The Company believes that returns in asset classes such as airports, healthcare are likely to generate incremental returns. We estimate that increasing the portion of active income to ~20% would be incremental to group pre-tax profit by ~$100m. In context pre-tax profit in FY24 is estimated at ~$650m.
To this end, it is worth noting that the valuation metrics for asset-light fund managers (i.e. P/E multiple and premium to NTA) highlighting the premium which investors are prepared to pay for the asset light earnings stream of funds managers.
There are several factors underpinning the investment case for DXS. Mainly, the Company’s office occupancy outperforming the market, as DXS is a clear beneficiary of the flight to quality. Other factors include improving office yield spreads supporting continued above-trend rental growth, as well as a minimal lease expiry profile.
Notwithstanding these factors, we contend that the currently substantial discount to NTA at which the shares currently trade is unlikely to materially correct until such time as:
i. Cap rates move lower, with a key indicator being upcoming sales of office assets in Australia, and
ii. DXS accelerates its shift towards an asset-light earnings stream without incurring a significant jump in gearing.
Dexus remains in a longer-term downtrend. However, shorter-term there appears to be further upside. It has recently tested the 2022 lows before bouncing strongly on good volume. This is a positive sign and so far we are seeing DXS move higher again. It should continue to head higher here in the short-term but longer-term it may just head sideways. Only a break of the February high would lead us to be positive longer-term on the chart.
Michael Gable is managing director of Fairmont Equities.
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