The news is remarkable these days. Pull out a newspaper or surf the Internet, and real life (or at least the economic and financial equivalent of it) is fascinating reading.
At the top of the list is the coverage of Australian real estate investment trusts or AREITs, the new stage name for listed property trusts (LPTs) — and stapled structures. In the past year alone, the Australian Securities Exchange (ASX) property index has fallen 60 per cent.
The only question more interesting than what went wrong is what happens next?
Let’s explore both.
What went wrong?
For you and me it was a simple formula: economic boom (treasure from commodities) combined with a credit card equals plasma from China.
While we should have been building roads, railways, renewable energy assets, and rain and wastewater reservoirs, we decided instead to go surfing in Bali. At least we took some nice photos along the way.
It wasn’t that much more complicated for LPTs.
For the decade up to 2008, making money in property was too easy. It didn’t matter if you paid a bit too much, the market was cantering along and would catch up soon enough.
But the one thing you absolutely, positively, could not afford to do was fall behind by letting that pesky competitor get the asset. Everyone was having a go at inflating the asset price bubble.
Debt was very, very good. The more you could spread over the wafer thin equity biscuit, the better. What could possibly go wrong? Stapled structures seemed to be breeding like rabbits: equity and layered debt with tied advisory and long-term management services were de rigueur.
In 2007, we were happily sitting in our leverage spa, the temperature slowly increasing. Just like the proverbial frog in the boiling water.
We were looking at each other and thinking everything was okay. After all, everyone else was doing the same thing — hooked on cheap and easy debt and borrowing big and then bigger on the basis of unrealised asset value gains.
Loan to value ratios (LVRs) of 60 per cent didn’t seem too high. Hell, some property funds had 70 per cent. At that level, a 15 per cent fall in value destroys 50 per cent of the equity. A 30 per cent fall means there’s no equity left and any bigger fall starts to hurt the banks.
Following the sort of tactics taught in ‘selling drugs 101’, property funds themselves were hooked on cheap and easy debt.
Roll on 2008, a brutal year. The asset price bubble burst. The credit tap, which had been turned on full and was spewing forth more credit than we could catch in our overflowing buckets, was suddenly and very tightly turned off. Obtaining new lines of credit or refinancing debt became a Herculean struggle.
The rest we all know too well: covenant breaches and pressure from the banks to reduce LVRs, too much supply and too little or no demand, weakening property prices and forced sales at lower prices — the start of the dizzy AREITs’ spiral.
The debt junkies forced to go cold turkey are finding it extremely painful. And, to round it off, we all get letters from our super funds telling us how many sizes our super pants have shrunk.
What happens next?
Well, now that we’re all up to date, what happens next? While the crystal ball is a bit cloudy, I think we can expect:
- de-leveraging — there will be lots of asset sales — get rid of that debt and bring down those LVRs much, much lower — 30 per cent might be the new norm;
- property fund managers will have some nasty decisions — which properties to sell? The good ones because that’s all that sellers will buy? But what does that leave you when the market turns?
- capital raisings — if, which seems doubtful, the market has the ability and appetite to invest;
- back to the future — fixed-term unlisted property trusts, remember those? Just like General MacArthur, they shall return. Don’t lose sleep over valuations and liquidity until the term is up; and
- shot-gun weddings — consolidations and mergers will be popular, especially scrip bids.
The more complex issues still to be resolved include:
- stapled structures — is the stapled structure Humpty Dumpty? Do we call in all the king’s horses and all the king’s men, or is it too late? For a while, stapling was all the go. If you weren’t stapled, the bouncers wouldn’t let you in. Now the combination seems to go together as well as long white socks and black sandals.
- passive landlords — will AREITs revert to boring but safe bricks and mortar investments, or will they become passive landlords collecting rents?
- management rights — it was meant to be a fundamental feature of an AREIT that the responsible entity could be removed by unitholders. Pity no one examined the loopholes more closely. The responsible entity smarties entered into big, long, sticky management contracts with related parties and entrenched themselves by having only a few express termination rights. Somehow, I don’t think that was intended. I wouldn’t have had any trouble in finding them void for public policy, but 10-year management agreements didn’t seem to faze the regulators.
There will be plenty in the newspapers to keep us interested for the next couple of years. Let’s face it, it was a pretty good party while it lasted, but what can you expect after a world record credit binge? The mother of all hangovers.
Anyone got some Panadol Forte?
James Lonie is a partner at law firm Henry Davis York (HDY), which has a financial services practice.
