Region Group Earnings: We Expect Growth To Resume Once Finance Costs Peak

No-moat Region Group’s RGN result was in line with our expectations, and management guidance. Funds from operations fell 2.6% to AUD 16.9 cents per security, Adjusted FFO, or AFFO, and distributions, were flat at AUD 15.3 and AUD 15.2 cps, respectively.

Rising finance costs offset revenue growth for the year, as higher interest rates boosted Region Group’s average cost of debt to 3.4% from 2.4%. We forecast debt costs gradually rising toward our long-term estimate of 6.5% by 2026—by then, interest rate hedges will expire and new debt will need to be issued at the going rate. We assume AFFO declines to AUD 13.7 cps in fiscal 2024 in line with management guidance, and bottoms in 2026 at AUD 11.9 cps.

Once interest costs peak, we expect revenue growth to drive low-single-digit earnings growth. Distributions should fairly closely match AFFO, given the REIT’s near-100% AFFO payout ratio.

Convenience retail REITs looked relatively expensive for the last couple of years. REITs that own offices and high-end malls fell sharply in 2022 when interest rates began to increase, but convenience retail initially held up. More recently, the sector has declined, and with Region Group now 27% lower than its 2022 peak, its securities screen as undervalued versus our unchanged AUD 2.55 fair value estimate. The REIT’s 6.0% fiscal 2024 AFFO yield looks attractive, considering a 10-year bond yield of 4.3% at the time of writing, and our assumption of moderate AFFO downside, followed by growth once interest costs peak.

We view Region Group as one of the more defensive Australian REITs. The average lease is 6.2 years, and about half the rental income comes from major anchor tenants such as Woolworths, Coles, and Wesfarmers, that we view as extremely unlikely to default. The other half is specialty tenants, many of which are also strong operators or, if necessary, able to be replaced by another firm paying a similar rent.