House rules: know your product
Since Centro Properties failed to refinance almost $4 billion in debt in December 2007 many investors in listed property feel like they have been on a roller-coaster — one headed straight over a cliff.
Far from its traditional image as a safe investment, listed property has taken advisers and their clients on a very hair-raising — and expensive — ride.
The market capitalisation of the 68 Australian real estate investment trusts (A-REITs) currently listed on the Australian Securities Exchange (ASX) is down from $148 billion at the end of August 2007 to $85 billion a year later. This represents a drop in value of 42.7 per cent over the past 12 months.
The decline has seen an ongoing wave of earnings downgrades, distribution cuts and redemption freezes convulse the entire property market.
The collapse in the value of A-REITs, which were previously referred to as listed property trusts (LPTs), has had a major impact because they make up one of the largest market sectors on the ASX.
According to Dugald Higgins, associate director at Property Investment Research, much of the shakeout is because of a changed perspective.
“Suddenly investors awoke to the fact that although LPT vehicles were seen as safe havens, that was not the case any more.”
This shift continues to influence sentiment towards the sector.
As the latest ING HouseView outlined, the sector is currently trading on a 2009 financial year prospective yield of 9.2 per cent, around 3 per cent higher than the 10-year bond yield. However, although this yield differential “appears attractive, we remain cautious on the sector”.
Property expert and managing director of Atchison Consulting, Ken Atchison, agreed there has been a major change in sentiment.
“We are undergoing a massive cleansing process in this market.”
The impact of the global credit crunch has changed the landscape markedly, according to Australian Unity’s head of strategy and portfolio management, Kirsty Dullahide.
“Capital management is the key to understanding what has happened,” she said.
“Previously, interest rates were low and banks had money to on-lend. It is a very different environment now. This makes capital management very important with an illiquid asset like property.”
Looking back for answers
According to Atchison, with the benefit of hindsight, three key factors were behind the sector’s decline. The first was the composition of the distributions paid to investors.
“The distributions paid by A-REITs was not just rental income … yields were being supported by considerable distribution of trust capital,” he said. This created a “misunderstanding” and “gave a false impression” of how some of the trusts were performing.
Higgins agreed capital return became an issue.
“It was good when things are going up, but now markets are suspicious of any debt, so it is a very big negative impact.”
The second problem came with the new activities many A-REITs moved into, such as property development and funds management.
As Higgins explained: “Traditionally they were ‘landowners’, but in the past five years they have moved away from being collectors of income streams to having high gearing and getting into foreign markets — even though this was good for diversification.”
Before the market turned, these activities were viewed as positives for a sector often seen as stuffy and old-fashioned.
“Commentators had been very critical about LPTs being too conservative, but now they are being hit for the changes they made,” Higgins said. “It is one of those circumstances that happens when the cycle turns.”
Atchison agreed views have turned sharply.
“These ‘extra-activities’ were priced as significant price/earnings (P/Es) multiples by the market. They were given premium pricing and that was a flawed approach,” he said. “There is now no value being given to those things, so that is just as extreme.”
Many of the woes that have befallen A-REITs are the result of these changes, according to Dullahide.
“LPTs are not just about property exposure; they have fund management, property and property development components,” she said.
“There are problems due to a recognition that capital management capacity is very critical … It is tied to the global credit issue, as this increasingly raised questions about the funds management capability of some vehicles.”
Dullahide believes negative sentiment has swept everything before it.
“Investor sentiment has come into play. The volatility in the sector is being driven by sentiment.”
The final issue behind the sector’s decline relates to the complex financial structuring that transformed what were simple vehicles based on rental income streams.
“They became convoluted, financially engineered structures which only got away because it was a bull market,” Atchison noted.
Investors failed to appreciate the scope of the structural changes occurring in the A-REIT sector, according to Dullahide.
“They are seen as a more traditional asset class, but this perception is not in line with the changed structures.”
How long will it last?
It seems the outlook for listed property is unlikely to change any time soon.
When Lonsec released its annual Australian Property Securities Fund Sector report in July, it noted the bad news “is likely to continue in the short to medium term, reflecting tough conditions (wider credit spreads) and A-REIT structural issues (financial engineering and unsustainably high payout ratios.
Atchison believes the worst is over, but like most experts has no idea when conditions will change.
“The pricing says cap rates are going to blow up, but the market evidence is that is not going to happen,” he said.
His firm tracked credit spreads as the listed market collapsed and is now starting to detect some positive signs. According to Atchison, spreads peaked around the time of the Bears Stern’s collapse before contracting and then blowing out again during the June/July period. However, they did not reach their previous peak.
“We see this as a measure of risk aversion, and credit spreads are giving an indication that investors are willing to start taking some risks again.”
Higgins expects the volatility to continue for some time.
“I would like to think we have seen the bottom, but there are too many unknowns — especially in the US.”
Dullahide agrees the high level of market volatility makes it difficult to predict future performance.
“There is so much uncertainty about … but the opportunity for upside is there.”
In a recent interview on ABC-TV, long-time market player and Mirvac Group managing director Greg Paramour was a bit more forthcoming.
"We’re at the dark side of the moon, we’ve got to get round the other side and that will take some time, and these cycles normally last, you know, one to five years.”
When the market does recover, Higgins believes this rout will be seen as fairly normal.
“When you take the really long-term view, this is just part of the cycle.”
Not a sunny outlook
When it comes to investment returns, sentiment remains pretty gloomy.
While the Lonsec report noted that on a selective basis there was some value, it remained wary.
“Investors should remain cautious and focus on the ‘plain vanilla’ property trusts that have a bias to Australian property, high occupancy, mostly rental income, reasonable levels of gearing and manageable lease and debt maturity profiles.”
Most experts agree there are buying opportunities.
“The market is now offering good opportunities in selected areas as you can buy assets at a discount to their value,” Atchison said.
"However, you need to ensure there are no remnants of the previous problems remaining before investing."
Improvements in the gearing levels of A-REITs are also a positive.
“Most of the A-REITs are selling properties and paying down debt, so there are decreasing debt levels,” noted Atchison.
Higgins agreed opportunities are emerging.
“Property is an illiquid asset class that can be traded in a liquid market, so there are big opportunities for mis-pricing. We see some significant opportunities if you are prepared to commit funds for the long-term.”
When it comes to property more generally, Higgins believes demand for real estate in Australia will remain strong.
“There will always be demand for real estate. Unlike equities it is very tangible, not ephemeral.”
He believes the current situation is unlike the property crash in the early 1990s, which was due to money flooding out of the share market and a subsequent building boom.
“This time we do not have the supply overhand and vacancy rates are quite good.”
While the media is reporting billions in property flooding the market, Dullahide believes Australia will be spared the oversupply problems occurring overseas.
“Although we are given pause by reports of huge amounts of property coming onto the market, it may not all actually occur,” she said.
Atchison believes the broad market fundamentals are reasonable. He sees rents in the office sector as quite strong, while the fundamentals of the retail sector remain reasonably positive, despite the slowing economic growth rate.
When it comes to industrial property, the supply/demand balance is less favourable, so while rents may rise, Atchison believes it is likely to be less than in other sectors.
Dullahide agreed with this view. “On the whole, I’m positive on the outlook.”
However, she feels the property market may still see a mild correction.
“In this environment, a cap rate correction of some sort is expected — probably 25 basis points.”
There is also concern about what the collapse in listed property means for the unlisted sector.
Higgins is cautious about the unlisted sector, particularly given the high prices paid for some properties in recent years.
“The unlisted sector needs to be careful as it has its own problems. It had yield compression of over 3 per cent over the past couple of years.”
The level of gearing in many unlisted trusts has increased to top up returns to investors, Higgins noted.
“In some trusts, up to 40 per cent of the return was return of capital, and now valuations are starting to unwind there could be problems.”
As this was a factor in the collapse of the listed market, Atchison believes it is vital for advisers to review the composition of distributions in clients’ unlisted property investments.
“You need to look through to determine if the rental yield is being supplemented by capital distributions.”
Atchison is more bearish on listed than unlisted property. “There is a lot of discussion that the listed market is implying cap rates on unlisted are going out a long way. We believe they will a bit, but nowhere near as high as the increases in the listed market,” he said.
“The listed market got very overvalued but now it is being priced back to sensible levels.”
The timing lag in property valuations for the unlisted sector raises some concerns for Higgins and he said it was becoming “increasingly common for unit prices to slide in the unlisted sector”.
Advice for financial planners
When it comes to listed property, the advice is clear.
“Planners need to ensure clients understand their property investments and what they represent in their portfolio and to reassure them that they do not need to be concerned about short-term volatility,” Higgins said.
Dullahide also believes understanding is vital.
“Advisers need to explain why the asset is in the portfolio and how it all fits together with the other assets … It is important to have a contextual conversation.”
For Atchison, it is all about why the allocation was made in the first place.
“It is important to remember that the income component is still there. It was overstated due to the capital distributions, but if an income stream was what you were investing for, then it remains relatively stable.”
Higgins agreed income is the heart of this asset class.
“Property is one-third growth and two-thirds income. In the past couple of years it changed to almost the reverse of that situation and that is not an ongoing position.”
Advisers and investors also need to understand the various products, as some are property-backed vehicles, rather than actual property investments.
“Ensure you understand what you are invested in and what the timeframe for that investment is,” Higgins cautioned.
The redemption problems being experienced by several hybrid funds also need to be considered by advisers.
“The message is the manager must have a well developed liquidity policy to avoid problems,” Atchison said.
The main tip for advisers and clients, however, is not to panic.
“The adviser needs to find out what the investor’s concerns are and address those — whether it is liquidity, price declines or volatility,” Dullahide said.
“Clients and advisers need to understand that property does have volatility associated with it. It is not the time to exit the sector and it may be time to reconsider the balance of investments in the portfolio.”
As a listed asset sometimes it will become overvalued and sometimes it will be undervalued.
“A-REITs are listed, so that provides liquidity, but part of the price of liquidity is high volatility. It reinforces the long-term focus that you need to take with investing in the listed market,” Atchison cautioned.
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