Listed property: Index caught by surprise

The full extent and secondary and tertiary impacts of the global financial crisis caught most investment managers by surprise. In Australia, the GFC was not specifically related to commercial property fundamentals because:

• there was no overbuilding;
• there was no oversupply;
• rents were forecast to increase.

Notwithstanding the above, the S&P/ASX 300 AREIT Index fell 76 per cent from its peak in 2007 to its trough in 2009. This result, while catastrophic, was actually tempered by the relatively strong performances of Westfield Group and CFS Retail, which only fell 53 per cent and 25 per cent respectively over the same period. With these two Australian real estate investment trusts stripped out, the rest of the index fell more than 90 per cent, and that is inclusive of dividends.

Putting it another way, at the peak of the AREIT market in February 2007, the median share price in the S&P/ASX 300 AREIT was $2.12 per share. At the bottom in March 2009, the median share price of the same index had fallen to a staggering 17 cents, a fall of 92 per cent.

At the bottom of the market in March 2009, our analysis showed that many AREITs were pricing in depression levels and a complete collapse in commercial property values which would bring in default risk into valuations. At the same time, there were several AREITS that were pricing on mild downturns in pricing valuations. Some investment managers saw the greatest value opportunity since the early 90s and went on the offensive as many smaller to mid-cap AREITS were trading at the time at a fraction of their NTA (net tangible sset value) per share.

One of the critical factors influencing share prices was the total uncertainty investors had regarding bank debt and commercial mortgages, whether they would be rolled over and extended and, if so, at what margin. Linked to this was the question of bank covenants and the triggers required to call in the debt. This led investors to believe there would be widespread defaults and therefore a fire sale of commercial properties.

In this environment, many AREIT prices fell over 90 per cent from peak to trough and this led to unprecedented buying opportunities. Subsequently, many AREITS have generated over 100 per cent return over the past six months, with some in excess of 200 per cent. The global financial crisis and subsequent recovery in the AREIT market has confirmed to us the founding driving principles in relation to valuing and analysing AREITs. These include:

1. Valuations

• Emphasis needs to be placed on assessing the capitalisation rates implied by market pricing. Analysing the gap between stated valuations and market valuations (implied cap rates of properties as opposed to what the valuers think) has worked extremely well. In particular more rational pricing has returned over the last 6 months.
• Use long-term, through-the-cycle capitalisation rates to position the portfolio accordingly.
• Do not rely on management statements. They are no substitute for sound and independent fundamental analysis.
• Concentrate on balance-sheet strength in times of extreme property pricing.
• Do not artificially constrain turnover, particularly in a volatile market. There are often enormous mispricing opportunities to take advantage of.

2. Gearing

• You cannot just focus on simplistic assessments of gearing, eg, low gearing = positive, high gearing = negative. The position in the property cycle, the timing of the debt rollover, direction of property values, how much debt is in separate off balance sheet vehicles, how much of the debt is truly non-recourse, etc — these are also strong determinants.
• One cannot look at gearing in isolation — it also must be looked at in relation to where current cap rates are trading relative to “through the cycle” cap rates. Don’t always position your portfolio for a one-in-100-year storm.

3. Behavioural

• Investors won’t often make their money back by holding onto their biggest losers. They are often better off selling out and buying stocks with better upside.
• Stocks don’t go to zero as often as investors think because they can raise capital.

AREITS — the new world

Many investors are afraid to go back into AREITS because of what has happened over the past two years. While this sentiment is understandable, we believe they are missing a significant long-term opportunity While it is important to always be cognisant of history, you should not necessarily build a portfolio solely designed around a one-in-100-year storm.

If investors are solely concerned about that 100-year storm, they are probably better off being invested in physical gold than property or shares.

The fundamental point is that AREITs have materially improved their risk characteristics in the past 12 months — in our view they are no longer high risk. Why is that? How have they done it? There are three fundamental factors:

1. AREITs now have materially lower gearing than two years ago (the sector is now down to 31 per cent gearing) by virtue of capital raisings in excess of $15 billion, and in some cases asset sales.

2. AREIT valuations have also been written down by approximately 20 per cent from their peak-valuation levels, so property prices are no longer materially overvalued in AREITs balance sheets.

3. AREITs have also lowered their payout ratios significantly so they are much less reliant on sourcing debt to pay distributions. This is a huge structural change which will make the AREIT sector far more stable long term.

Portfolio positioning — the ‘Westfield factor’

One significant negative issue does remain — the dominance of one AREIT in the Index — Westfield Group. As at September 11, 2009, the S&P/ASX 300 AREIT Index weight of Westfield Group was approximately 42 per cent. This is a serious issue — we believe as a result, the index itself is not sufficiently diversified, and that investors who are seeking safety by investing passively in the index weights are taking a (lack of) diversification risk that they may not be aware of.

Our EQT SGH Property Income Fund explicitly addresses this Westfield dominance in the index by capping the maximum weight of any security. The Westfield weight is currently approximately 2 per cent, compared to the 42 per cent index weight, in the fund. We believe the real opportunities to make money lie elsewhere.

Despite a significant recovery in the index, the EQT SGH Property Income Fund is still trading at a significant discount to where SGH believes the bottom of the market direct property price cycle would value these AREITs. SGH expects direct property market prices to bottom H2 2009, but EQT SGH PIF is still trading well below these levels.

Stephen Hiscock and Grant Berry are portfolio managers for SG Hiscock & Co.