The push for full disclosure of REIT gearing levels

Ed Psaltis explains why there is an increasing appetite for full disclosure of REIT gearing levels.

As gearing levels have continued to rise across the Australian real estate investment trust (REIT) sector, investors are scrutinising the true gearing levels of many REITs.

While Australian REITs are fully compliant in their basic gearing disclosure under International Financial Reporting Standards (IFRS), the need for greater transparency towards ‘look through’ gearing levels is paramount for investors.

It became evident when poring through REIT financial data for the inaugural PKF REIT Monitor that it has become difficult for analysts and investors to gauge the true extent of gearing for many REITs.

This is due to the proliferation of joint ventures and associated investments, which are now a far more dominant feature in listed REITs.

Thirty of the 48 Australian REITs have these kinds of investments on their balance sheets.

However, under IFRS as interpreted by the relevant REITs, they did not have to fully disclose details of debt within the investments, such as their ‘look though’ gearing level (which includes all equity-accounted assets and interest-bearing liabilities).

Only 20 of the 48 Australian REITs disclosed their ‘look through’ gearing position.

Where it was disclosed, the level of gearing invariably increased.

While all REITs appear to have complied with their IFRS requirements, it would be helpful to have financial instrument risk disclosures in the financial reports of REITs.

These could include debt maturity profiles, types of debt and gearing levels — not just covering the REIT itself, but also for any joint ventures and investments in associates the REIT might have.

The lack of consistent ‘look through’ gearing disclosure in the REIT sector may conceal higher gearing levels than was previously thought.

While the reported average basic gearing for Australia at the end of June 2009 was an already high 47 per cent, the reality would have been even higher when taking into consideration the ‘look through’.

Ideally, all REITs should disclose their true level of ‘look through’ gearing in their financial reporting, even if that figure is the same as basic balance sheet gearing.

Two sides of the same coin

Despite the reported $11 billion in equity raisings in Australian REITs over the 2008-09 financial year (which was used almost entirely to reduce debt), gearing levels rose from 42 per cent to 47 per cent.

This was due to the fact that, over the same period, properties within all REITs were written down by approximately $20 billion. Never before has a fall in value of this magnitude occurred in listed REITs in Australia.

This blew away the effect of equity raisings, and led to the headline increase in average gearing for the sector. In the end, despite concerted efforts by all to reduce gearing, 75 per cent of REITs saw an increase in their gearing level.

However, there has also been a real spilt in the REIT sector, dividing it between the ‘haves’ and the ‘have nots’.

The ‘haves’ are mostly the larger REITs with successfully reduced gearing levels. In fact, the average gearing of the ‘Big Eight’ (see Table 1) was 27.7 per cent on June 30.

Even excluding Goodman International (due to its still high gearing level), the remaining seven enjoyed an average gearing level of just 24 per cent compared to the above-sector average of 47 per cent.

The last time the sector average for all REITs was 24 per cent was a decade ago.

Perhaps this is a case of ‘back to the future’?

The discrepancy between the ability of Big Eight listed REITs and the other REIT players to secure medium-term notes and raise capital (ie, to help reduce gearing) is interesting.

A decade ago, medium-term secured notes did not exist within REITs and the only form of lending came from ‘plain vanilla’ bank debt.

However, although medium term notes are now the second largest form of debt financing after commercial bank debt, the ability to raise funds via these notes appears to be a privilege.

The Big Eight represent the closed club that has been able to access longer-term maturity (and often lower-debt cost) medium-term notes.

These eight REITs are:

• Westfield Group
• StocklandGroup
• MirvacGroup
• CFS Retail Property Trust
• Commonwealth Office Property Fund
• Dexus Property Group
• GPT Group, and
• Goodman International.

This list represents the REITs with the most financially robust balance sheets, low gearing (mostly below 30 per cent) and major recapitalisations (for the most part).

Only one smaller sized REIT — ALE Property Group, which mainly holds long-term leases (15 years plus) predominantly with a very high creditworthy tenant — achieved funding through this attractive medium-term note market.

Both factors would have opened the door to the private club, notwithstanding ALE’s relatively small size.

Storm clouds clearing for M&As

Since the REIT market is either bottoming out or beginning its recovery, the dam walls holding back a potential flood of mergers and acquisitions (M&As) may soon give way.

However, there are several obstacles that must be overcome before these transactions can materialise.

About 15 months ago there were five main obstacles to potential M&A activity, including:

• The reluctance of banks to provide debt for acquisitions;
• The likely dilution for unit holders created by acquirers issuing new equity in their REITs at current prices;
• The renegotiation of banking covenants and the cost of debt, triggered due to clauses in financing agreements regarding changes of ownership. A change in ownership of a REIT allows banks to renegotiate all terms to more favourable levels for them, and can even allow banks to call in the debt.
• ‘Poison pills’: clauses typically included in fund manager agreements that provide for significant fees or other considerations, payable to existing fund managers as compensation in the event of a change of ownership.
• Fears about just where the bottom of the market was, given the collapse of Lehman Brothers in the US had caused further erosion in stock market value.

Given these problems, any M&As conducted in 2010 will have to be friendly rather than hostile, because support from the banks is essential. In such transactions, in order for viable acquisitions to occur, all stakeholders involved must be convinced that they will benefit from the transaction.

It should be noted that two of these five obstacles are no longer present in the current REIT market. Firstly, 15 months ago there had been very few capital raisings in the sector, due to the damage that discounted raisings would do to the position of existing unit holders.

However, in the intervening period, $14 billion plus in capital has been raised notwithstanding the heavy dilution in their investment that many investors suffered — some of the capital raisings at discounts of up to 50 per cent on market price.

But now the REITs that raised capital to pay down debt have far more robust balance sheets.

These REITs are now in a position to actively seek M&A opportunities, given their low gearing now compared to before the global financial crisis.

Secondly, while it cannot be sure that REITs have hit bottom in terms of ASX pricing, the sector is a lot closer to that stage than 15 months ago. If we are not already at the bottom, we are definitely close.

Most of the Big Eight REITs have shifted from having no excess capacity in their funding to the point where capital raisings have strengthened balance sheets so much that M&As are again viable propositions.

However, it still holds that any M&A transaction would need to be earnings accretive while remaining true to the ‘back to basics’ approach that the market now expects of REITs.

Comparison across the Tasman

In comparison with the Australian REIT market, New Zealand’s REIT sector was found to be in better health across all areas analysed by PKF:

• the New Zealand market had far less exposure to short-term debt maturity (15 per cent compared to Australia’s 28 per cent);
• the market in New Zealand also had no reliance on the very tight commercial mortgage-backed securitisation market (compared to Australia’s 11 per cent);
• the average gearing of New Zealand REITs was 13 per cent lower than Australian REITs (34 per cent compared to Australia’s 47 per cent); and
• New Zealand had a much lower discount of market price against net tangible assets (30 per cent in New Zealand compared to a 54 per cent discount in Australia).

Though Australian and New Zealand REITs operate in markets of significantly different sizes, their comparison provides an interesting perspective when analysing the health of the Australian REIT sector.

It is fair to say that over the past six years, New Zealand REITs did not go down the ‘higher return but higher risk’ path of their cousins in Australia.

New Zealand REITs also avoided ramping up gearing levels, and had no investment in overseas property within their portfolios.

Australia, on the other hand, used that increased gearing to invest heavily into the US, followed by Europe and finally, into Japan and the detrimental outcome of these investments is well documented.

Furthermore, New Zealand REITs did not embrace stapled security the way Australian REITs did.

The more aggressive of these in Australia raised the portion of their active (higher risk) business income significantly, eroding the once-dominant position of passive property investment (the type of investment that originally made REITs strong).

The last full financial year drastically changed the REIT landscape in Australia. Despite concerted capital raising efforts, debt and increased gearing levels remain significant issues for REITs and their investors.

This is especially true for the majority of REITS that fall outside the Big Eight club.

Several of these REITS have managed to obtain a private equity investor to rebuild their balance sheet position.

However, these are still the minority when all 48 listed Australian REITs are taken into account.

REITs still have a long way to go before their gearing returns to comfortable levels. It is hoped that increased transparency and a continued effort to reduce basic and ‘look through’ gearing will ensure the future health of REITs in Australia.

Ed Psaltis is a corporate advisory partner and REIT sector specialist at PKF Chartered Accountants & Business Advisers.