The continuing rise of property - listed property

Listed property trusts have lost the gloss that saw them shine through 1998. But, as Peter Lavelle reports, a downturn in the market is also a clear buy signal.

Listed property trusts have lost the gloss that saw them shine through 1998. But, as Peter Lavelle reports, a downturn in the market is also a clear buy signal.

Brokers and analysts are taking a close look at the listed property trust sector, as a sell-off over recent months has priced them below real value and raised yields to a three-year high.

As a result, financial planners and brokers are recommending listed property trusts (LPTs) to those small investors looking for an income stream such as self-managed super funds, retirees amongst others.

A year ago it was a different story, with financial planners and bro-kers steering their clients clear of the sector.

"Last year we saw an outflow of funds out of growth shares - espe-cially those that had anything to do with Asia - into defensive sec-tors of the market, especially listed property trusts," says Howard Brenchely, a director of APN Funds Management. Unit prices became overvalued, he says.

But with the Asian economies turning around, and a confidence in both US and local economies, institutions are now reweighting in favour of growth shares, especially cyclicals and resources. So LPTs have lost their flavour of the month status.

The bond market has also played a role. Last year, ten-year bond yields rose from 5 per cent to 6 per cent and investors began to switch out of LPTs and back into bonds.

"There's generally an inverse relationship between LPT yields and bond yields," says Brenchley. "When ten-year bond yields fall, prop-erty trusts become more attractive. When they rise, investors prefer bonds."

Currently, the sell-down of LPTs has raised yields to the point where they are at historic highs above ten-year bond yields. The average yields for listed property trusts has risen from 6.9 last year to 7.9 per cent - making returns from LPTs currently better than those from fixed interest and cash management trusts.

Not only are yields high, but the sell-off has pushed unit prices significantly below real value, Brenchley argues. He says they are now trading at a 5 per cent discount to value, based on five years of estimated forward cash flow (discounted back to present day values).

His is a conservative estimate compared to some brokers who put the discount-to-value at 6.6 per cent (JB Were), 7 per cent (Merril Lynch ) and 8.3 per cent (Warburg Dillon Read).

By another method of estimating value, the premium to net tangible assets (NTA), the sector is also improving in value. Last year the LPT sector's premium to NTA was about 18 per cent. It's currently closer to about 5 per cent, says Kim Wright, associate director of property analysis at broking firm Warburg Dillon Read. This repre-sents a three-year low.

However, according to Dr Frank Gelber, chief economist at BIS Shrap-nel, it's important to realise a discount to value is a good buy sig-nal, but only if the underlying assets have good prospects.

But here too, the picture is a positive one, thanks to sound underly-ing property fundamentals.

Brokers are forecasting earnings growth from property revaluations and rental increases - which historically translates through to growth in distributions (and hence unit prices) - from about 1. 5 to 3 per cent or more for the next year, and overall returns to uni-tholders (yields plus capital growth) of about 12 per cent.

Merril Lynch, for example, is predicting growth in distributions of at least 2.6 per cent per annum over the next three years and is predicting average returns across the LPT sector of 12 per cent for the next 12 months. The group expects the sector will outperform the All Ords over this time.

Of the subsectors, retail was the most overvalued last year, but has come down closer to true value, Gelber says. Retail earnings are solid, and predicted to grow at between 3 and 4 per cent annually, driven by good consumer sentiment as well as sales and rental growth.

Industrial trusts too are performing well, chiefly because the econ-omy, to which they are linked, is growing at 3 per cent currently, leading to similar annual rental growth rates.

But it is the office sector that's the surprise listed property bar-gain, according to analysts. Concerned about oversupply, especially in Sydney, the market sold down the office sector more heavily than any other, driving yields up to a current average of 8.3 per cent. But the office market is strong, and with vacancy rates falling and rents rising in Sydney and Melbourne - and bearing in mind the sector is trading at lower premiums to net asset backing than retail or in-dustrial - the office sector is a buy, Gelber says.

Put it all together and LPTs - especially the office sector - are looking attractive, with little relatively little downside side risk, with a good long term capital growth prospects and a high yield. And there is also a potential upside to investors from the wave of merger activity taking place in the sector.

Last year there were four mergers. AMP took over GRW, Stockland ac-quired

FAI's trust operation and Colonial First Sate took out Legal and Gen-eral and Prudential. This year, three Mirvac trusts announced plans to merge, and Goodman Hardie launched a bid for Capcount Property Trust.

According to broking firm Warburg Dillon Read there will be another six to eight mergers in the next financial year.

Most of the activity involves the takeover of smaller trusts by larger ones, in the search for greater size and liquidity.

"It's also a way for the big funds to buy property assets on the cheap, as their targets are undervalued relative to their underlying assets," says Kim Wright at

Warburg Dillon Read.

For unit holders it often means a takeover premium for their units. For example, on the announcement of the merger of Mirvac Trust, Capi-tal Property Trust and Mirvac Limited, unit prices for these trusts jumped 15 per cent, though they've fallen back since then with the general falls in the market, says Howard Brenchley.

If it's all so rosy, then why do LPTs remain undervalued? Why hasn't the market pushed up unit prices and lowered yields already? And how long will the sector stay good value?

According to Kim Wright, small investors are buying, but institu-tional investors, particularly balanced funds- are more concerned with reweighting back into growth shares, and they are the ones driv-ing the market. But the situation may change if the institutions again decide to take defensive positions - if there are further falls in shares, for example.

There is also the risk down the line for investors if bond yields blow out.

"If bond yields stay as they are at around 6 per cent as we expect, then the LPTs will stay buoyant. But if bond yields climb above 6.5 per cent, then there may be some selling down of LPTs," Wright says.

Another ongoing thorn in the side of LPT investors is the uncertainty surrounding the tax treatment of trusts. The government's stated in-tention was to tax trusts the same way as companies, forcing them to pay tax and distribute franked dividends, rather than the current situation where they distribute all their net profit free of tax with distributions taxed in the hands of unitholders.

Should this happen, it would penalise smaller investors in particu-lar, who would have to wait until the end of the financial year to claim back credits, and who, if they're on a low income, may get franking credits they can't use anyway.

According to Howard Brenchley, the situation has eased in recent months following the release of the Ralph Report, which recommended against the proposed changes, and a recent statement from Treasury that it will exclude what it calls "widely held" trusts - thought to mean pooled unit trusts - from the proposed tax changes.

Investors remain concerned, however, that property trusts may lose their building, plant and equipment depreciation tax benefits, denying unit holders tax-free and tax-deferred income from LPTs in future.