Listed property on a slow road to recovery

Listed property has recovered since the massive lows of the global financial crisis, but there are plenty of challenges ahead for the industry, particularly investor sentiment, writes Caroline Munro.

Property was meant to be defensive, but it certainly did not behave as such during the severe market downturn.

Listed property particularly plummeted during the global financial crisis (GFC), and continued to fall until it bottomed out in March 2009.

Since then it has recovered quite well, although it still has some way to go to reach its former peak at the end of 2007.

BT Investment Management property portfolio manager, Julia Forrest, says that over 2008 and 2009 Australian real estate investments trusts (AREITs) failed to provide the diversification benefits that real estate was meant to provide due to high gearing and diversification into operations and overseas markets at the wrong point in the cycle.

“As a result, AREIT managers raised a large amount of capital at an extremely expensive price,” she says.

Charter Hall Group’s joint managing director, David Harrison, says retail investors remain cautious about the REITs sector because of the volatility of share prices and the greater volatility of earnings.

“The earnings in the listed REITs sector have been more volatile than the earnings in underlying direct property because of the discounted equity raising in 2008 and 2009 — and doing discounted REITs issue significantly reduces net tangible assets (NTA), but more savagely earnings per share.”

Harrison says the upward climb from its March 2009 lows was more a “catch up” between the gap of where REITs were trading and their underlying net tangible assets (NTA).

However the sector appears to have learnt the lesson of the GFC, moving away from inappropriate gearing levels and exposures, and reverting to conservatism. There is a general feeling that the worst is over for listed property, but sentiment is tentative as the sector still has some challenges ahead.

Slow and steady

As at August 31, 2010, the S&P/ASX 200 AREIT (sector) index showed an annualised one-year performance of -0.19 per cent.

According to Standard and Poor’s (S&P) second quarter 2010 global property and REIT indices quantitative analysis report as at June 30, 2010, Australian property returned 25.84 per cent over the last 12 months and a year-to-date (YTD) return of -10.12 per cent.

In terms of REITs there was a 12 month return of 26.20 per cent and a YTD return of -8.74 per cent.

Lonsec’s 2010 Australian Property Sector Review of 19 Australian property securities funds, released in July, noted that AREITs have improved steadily since the GFC, with a return of 37.8 per cent in the 12 months to May 31, 2010.

Property Investment Research’s managing director and head of property, Dinesh Pillutla, has a positive outlook for the sector over the next 12 months, adding that asset values will appreciate modestly due to new fund inflows and increasing merger and acquisition activity.

He says the sector has significantly reduced debt and generally has a strategy in place to run predominately Australian-centric portfolios.

But he adds that the next step and the key challenge is how to deliver growth. While they have reduced debt and have a strategy in place going forward, Pillutla asserts that the next key variable to focus on is earnings growth and therefore distribution growth.

AMP Capital Investor’s global portfolio manager for property, Brett Ward, agrees that listed property has rallied.

“There has been a very strong recovery, but importantly when investors have been considering the value proposition the sector is still quite a long way from its previous peaks,” he notes.

“We have had a good rally, but where do we sit in valuation terms?”

Ward says it’s a longer road to peak values, and even then he questions the likelihood of the sector returning to those peak values as the fundamentals that underpinned that growth have changed.

He says rather than looking at where the sector sits today versus the previous peak, AMP Capital prefers to explain to investors that the sector has rallied and while it hasn’t gone back to those peak values, valuations look more sustainable.

Charter Hall Direct Property chief executive, Richard Stacker, asserts that there is likely to be a gradual recovery, which he added is what people want to see.

He says investors want to see a normalised property market and “not necessarily something that is overheated”.

“From a performance perspective people are seeing that it’s bottomed and that this is probably the best time to invest,” Stacker says, adding that he is starting to see increasing interest from institutions.

Ward says institutional investors have maintained exposure to the sector and are allocating new funds to global real estate securities.

“Investor demand for this sector has been maintained, as we’ve seen in the medium to longer-term,” says Ward.

“There has been some money allocated to the sector, but from a funds flow perspective it has been a little bit quieter this year.”

Harrison says the interest in REITs will improve over the next 12 to 18 months, as investors get more confident about earnings.

“And more importantly, retail investors are feeling that their distributions will start to rise, because they’ve had a pretty horrid time in terms of falling distributions,” he says.

“Looking forward, the conundrum in the REIT sector is that there is confidence that real estate values are stabilised and will at least start rising in line with income growth in the underlying properties.

"But there’s an earnings drag. For a lot of REITs, FY11 is going to be the trough of earnings.”

Harrison says that the real difference between the direct market and the REIT sector was that REITs are still catching up with the real cost of debt.

“Pre-global financial crisis debt facilities have rolled off in the last 12 months and had to be refinanced at higher margins, which means that the cost of debt is reducing earnings in FY11 versus FY10,” he explains.

Pillutla agrees that the cost of funding will be a key challenge going forward, as it is not an issue of access to debt but rather a function of margins being charged.

He says the margin spread between quality AREITs and other AREITs has increased over the last 12 months.

Australian Unity’s general manager of property, Mark Pratt warns that a lot of debt will start maturing for both listed and unlisted property.

“Next year, there is a lot of debt in both listed and unlisted markets maturing — in 2009 they were trying to get debt and didn’t want to take it for too long.

"The banks know that and they are planning around that, so you’ve got to be aware of that as well,” he asserts, adding that there will be a new price for debt that investors will have to consider.

However, Pillutla remains positive that investors will see increasing distributions.

“I think come the next reporting season we should see a little bit more positive commentary around distributions,” he says.

“AREIT managers’ guidance for FY11 suggests flat to modest distribution growth. Beyond this, we expect distributions growth in the order of 2-3 per cent over the medium term.”

The Lonsec review also has a positive outlook for REITs and Lonsec investment analyst Thembi Matabiswana notes in the report that AREITS with robust capital structures will be able to fund earnings accretive acquisitions, which she says has been seen already.

“A key concern however is that the sector will contract before it ‘expands’ into a truly diversified exposure to Australian listed property,” she says.

“A number of initial public offerings scheduled have since been scrapped, simply because they cannot list at a discount to NTA given the costs involved in listing.”

She notes that the sector is still trading at a “significant” discount to NTA, compared to a 10-year average of a 22 per cent premium.

“This shows both the extent of the current recovery but also the fact that there is a long way to go before it gets back to normalised levels,” Matabiswana says.

Lessons learnt

The GFC put to bed the idea that REITs were safe as houses, although some would argue that managers have learnt their lesson and REITs have reverted back to the defensive, conservative investment they were meant to be.

“I hope we don’t go back into the big high growth ventures that got the sector into problems in 2006 and 2007,” says Forrest.

“For the next 12 months I think it’s going to be business as normal in terms of where our core competencies lie, what our balance sheets look like, and what is a sustainable payout ratio.

“If the broader equity market starts to run and REITs feel that they need to compete with the equity market for capital, that’s when mistakes can be made again.”

Matabiswana states in her report that the “dilutive” capital raisings last year will mean minimal earnings growth “at best”, adding that AREITS are reverting back to what they should be — “predictably boring listed Australian property vehicles, with steady yields and a low correlation to the broader market”.

Forrest says the sector was not meant to behave in the way that it did between 2007 and 2009.

“It wasn’t meant to be highly geared; it wasn’t meant to have all these peripheral businesses; it wasn’t meant to have a massive portion of its earnings coming from offshore, which were subject to currency volatility. I think if there was another downturn now, the sector would perform very differently,” she asserts.

Forrest believes portfolio managers have learnt their lesson, which is why REITs have performed so well in the last three or four months.

“It’s relatively lowly geared and it should be fairly defensive if the market turns down. The majority of the return comes from dividend — so you’re not depending on P/E expansion — and you would hope that the majority of the managers that are continuing to manage these trusts have learnt a good lesson.”

The Lonsec report found that the listed property sector has cleaned itself up, with gearing at “all time lows”.

Matabiswana also voices the hope that managers have learnt the lessons of excessive financial leverage and non-performing offshore assets.

However, she states that the sector has suffered a “significant loss of talent” following the GFC, with many of the senior analysts and portfolio managers leaving to be replaced by those with unproven portfolio management track records.

This so called loss of talent is at odds with Forrest’s assertion that many managers have remained, which she felt was a good thing (even if there is a temptation to get rid of those who made the mistakes in the first place).

“Sometimes it’s good for managers to have learnt their lesson and continue to be there, as opposed to getting in a whole brand new breed of new managers, who may potentially make the same errors three or four years later,” Forrest says.

“You would hope that they have learnt from that experience.”

An interesting finding of the Lonsec report is that the majority of funds in its review were still charging relatively high fees for low conviction active management, which it states was disappointing. Matabiswana notes that during the GFC, the majority of active managers underperformed their benchmarks while still charging active management fees.

According to the Standard & Poor’s Index Versus Active Funds Australia Scorecard Mid-Year 2010 report, the majority of Australian equity AREIT funds have underperformed relative to the S&P/ASX 200 AREIT index across all time periods.

It found that about 88 per cent of active AREIT funds failed to beat the benchmark over the last year.

Over the last five years, the index beat about 62 per cent of active AREIT funds. However, the report highlights that despite these results, the peer group enjoyed the highest survivorship rate (91.78 per cent) over the five-year period compared to other sectors.

Uphill battle

While the listed property sector is recovering, fund managers still have a battle ahead in winning over investors and advisers.

Forrest agrees that sentiment remains “tentative”.

“The way the sector performed when it really should have been a defensive asset class really disappointed a lot of people. I think it’s going to take a long time to win back confidence. It’s probably going to take another six to 12 months,” she says.

“A lot of the LPTs [listed property trusts] have recapitalised, they’ve flogged non-core businesses, they’ve bought all the capital back to Australia and exited offshore businesses, and exited businesses where they’ve had non-core competency.

"I think that process means that earnings growth is going to be hampered in the short term, but in terms of balancing strength and the sustainability of dividends, I think that’s going to win confidence back.”

Stacker says there’s no secret that property experienced a few issues during the GFC.

“That has caused issues of confidence, both at the investor and the adviser level,” he says.

However, he notes that Charter Hall research indicates a renewed interest in property investing among advisers, mostly those dealing in the high-net worth and self-managed super fund sector.

The research, conducted by Rainmaker, reveals that 24 per cent of 700 advisers surveyed planned to increase their clients’ allocation to property, with a particular preference for Australian property (51 per cent).

“There’s definitely adviser demand for listed as well as unlisted property,” says Stacker.

Ward agrees that financial advisers are slowly warming to property investments, although convincing them is an uphill battle. He says a lot of work needs to be done around education to engage advisers and part of that education process is explaining that the sector had reverted to “first principles”.

“The sector has changed from what it was two years ago,” he says.

“Leverage has changed the medium to longer-term return profile of the sector, and in some ways I think it is going back to what it was meant to be, which was a longer-term return derived from real estate.”

Stacker asserts that it is the fund managers that make a concerted effort to engage and educate advisers that will be the ones to win confidence back.

“If you are willing to educate advisers and investors — it’s part of what they are looking for. Those that are just going out and selling product are unlikely to get flows.”