The investment outlook for the property sector seems polarised between those who see a continuation of the rally and those who continue to give the sector a wide berth.
The market has come a long way since March 2009, when near capitulation selling suggested it would never recover. At the time, the credit crisis was entrenched in investors’ psyche and the overwhelming prognosis was that the listed property sector would continue to falter, driven by a combination of factors such as looming debt maturities, falling property valuations and an increasing risk of loans breaching key covenant thresholds.
These issues culminated in a severe market fall of 79 per cent between February 2007 and March 2009, but while some risks remain, the market has since rallied some 66 per cent. Nevertheless, this still leaves the market well below its historical highs, though we believe it is likely to see further gains in coming years.
The foundations of the recovery go back to the dark days in March. The problems facing real estate investment trusts (REITs) could no longer be ignored, forcing managements to take action. Since then a number of themes look to be shaping a healthier future for the Australian real estate investment trust (AREIT) market.
Recapitalisations, asset sales and deleveraging, along with dividend cuts or suspensions and the management of property devaluations and debt covenant breaches, have all featured prominently.
A total of $10 billion was raised in the first half of 2009 and several trusts came back to the market for a second round of new equity, having tapped it in the December 2008 quarter to the tune of $5 billion. While highly dilutionary, this has left the largest stocks with an average gearing ratio of less than 30 per cent and in a much better position to refinance their debt maturities as they come up over the next couple of years. Furthermore, it also eases pressure on covenant gearing ratios despite property devaluations.
There are, however, a number of smaller stocks that have not had the same access to equity capital and for which gearing remains relatively high. These REITs have typically been pursuing asset sales with varying degrees of success. Some have also retained distributions in order to reduce debt. To date, these initiatives have been sufficient for lenders to refinance their debt facilities, albeit at much higher interest margins.
Trusts in this situation exhibit what could be considered high-risk value, trading at very deep discounts to underlying net asset values (NAVs). These REITs typically have ongoing issues to resolve and their ultimate prospects will be determined via a range of outcomes such as successful asset sales and return of capital, takeovers, mergers and privatisations, or their ability to simply de-gear to a tolerable level and ride out the cycle over the medium to longer term.
A further positive has been a slight acceleration in asset sales in recent months. Buy/sell spreads have narrowed as a result of falling valuations and ‘forced’ sellers have therefore shown an increasing willingness to accept lower prices. This has helped the market find a clearing price and, therefore, a floor. The large amount of new equity capital raised is also leading to fewer trusts being considered distressed sellers, which has seen the withdrawal of much of the stock for sale, making potential purchasers take a more serious look at what properties remain up for grabs.
On the distribution front, most trusts have reviewed their policies, choosing to either suspend payments or to limit (cut) payments out of free cash flow. In the first instance, we see this as a healthy measure as the share prices of these trusts are typically so depressed that access to new equity is prohibitive.
This action assists in reducing debt levels until they are able to de-gear via asset sales. On the other hand, trusts electing to only pay out distributions from free cash flow, thereby retaining sufficient income to cover maintenance capital expenditure, prevents an unnecessary increase in gearing.
We have also seen a rational response from lenders towards trusts that have breached their loan to value ratio covenants. In this light, several trusts are currently in negotiation with their bankers to lift or remove covenants in exchange for higher margins, something banks have for the most part shown a willingness to do, so long as the trust in question enters a program of asset sales and de-leveraging over a specified period, typically one to two years.
And one final yet very interesting development has been the reopening of the corporate debt market for AREITs. In May, Westfield issued US$700 million into the US and Colonial Retail issued A$225 million of medium term notes in the Australian market. More recently, Westfield was able to tap the US corporate debt market for another US$2 billion at reasonable pricing while Macquarie Countrywide was able to price a $265 million, three-year commercial mortgage-backed securities (CMBS) issue in Australia.
This is significant because up until now, the belief was that the CMBS door remained firmly shut. It is a positive sign for the sector, and in the longer term we would expect it to broaden beyond the top few stocks.
In light of this, perhaps the best indicator of improving sentiment was the performance of the sector over the course of the reporting season in August. In the face of massive write-downs and more than $13 billion in reported losses, the sector managed to surge ahead 16.1 per cent.
The reporting season was always going to be tough, but the sector was able to shrug off much of the bad news. Property devaluations were not a surprise as many had been pre-announced during July. In general, property values in Australia fell between 5 per cent for regional shopping centres and 15 per cent for industrial, with heavier falls for US properties.
On the income side, most trusts delivered reasonable increases in comparable net property income over the financial year, showing good resilience against a tough economic backdrop.
However, guidance did typically warn that this metric would deteriorate, as office trusts face higher vacancies and expensive leasing incentives, and retail trusts face slower rental growth than what they have experienced in recent years. Additionally, a higher interest margin on debt needs to be factored in as facilities are refinanced at maturity.
In terms of the expectations for 2010, the majority of trusts are facing lower earnings per unit than they delivered in 2009 as a result of equity raisings and/or asset sales and higher interest costs. However, the AREIT market remains relatively cheap despite the discount to net asset value narrowing in recent months, and it is worth noting that analysts have pushed cap rates to cyclical highs and projected property values to cyclical lows.
With reporting season now complete, the following observations can be made. Firstly, the larger AREITs have now raised enough capital to absorb expected falls in valuations. With more prudent levels of gearing, this mitigates much of the risk of breaching debt covenants. In turn, capital raisings have reduced the amount of assets for sale in Australia.
With several sellers no longer under pressure, this assists in setting a floor for the market. While asset sales are expected to continue, for the better capitalised trusts it is more likely to be a matter of cleaning out non-core, lesser quality properties in Australia and exiting most offshore markets.
Banks continue to remain sensible and are not foreclosing, however, they are being tough on pricing, with margins on refinancing coming in around 300 basis points to 500 basis points, which are likely to be the cyclical peak in margins. Evidence of debt markets reopening is a further positive for the market moving forward.
Further dilution from capital raisings, margin increases and asset sales are expected, but the impact on the sector yield will be limited as most of the larger AREITs have completed their required capital raising/asset sales.
And finally, takeover activity in the sector is a possibility. Already we have seen a partial offer for Tishman Speyer, and it should be noted that some of the larger raisings both in Australia and abroad have been earmarked for acquisitions.
<br Patrick Noble is a senior investment specialist at Zurich Financial Services.
