House rules: know your product

Since Centro Properties failed to refinance almost $4 billion in debt in Decem­ber 2007 many investors in list­ed property feel like they have been on a roller-coaster — one headed straight over a cliff.

Far from its traditional image as a safe investment, listed prop­erty has taken advisers and their clients on a very hair-raising — and expensive — ride.

The market capitalisation of the 68 Australian real estate investment trusts (A-REITs) cur­rently listed on the Australian Securities Exchange (ASX) is down from $148 billion at the end of August 2007 to $85 bil­lion a year later. This represents a drop in value of 42.7 per cent over the past 12 months.

The decline has seen an ongo­ing wave of earnings down­grades, distribution cuts and redemption freezes convulse the entire property market.

The collapse in the value of A-REITs, which were previously referred to as listed property trusts (LPTs), has had a major impact because they make up one of the largest market sectors on the ASX.

According to Dugald Higgins, associate director at Property Investment Research, much of the shakeout is because of a changed perspective.

“Suddenly investors awoke to the fact that although LPT vehi­cles were seen as safe havens, that was not the case any more.”

This shift continues to influence sentiment towards the sector.

As the latest ING HouseView outlined, the sector is currently trading on a 2009 financial year prospective yield of 9.2 per cent, around 3 per cent higher than the 10-year bond yield. However, although this yield differential “appears attractive, we remain cautious on the sector”.

Property expert and managing director of Atchison Consulting, Ken Atchison, agreed there has been a major change in sentiment.

“We are undergoing a massive cleansing process in this market.”

The impact of the global credit crunch has changed the landscape markedly, according to Australian Unity’s head of strategy and port­folio management, Kirsty Dul­lahide.

“Capital management is the key to understanding what has hap­pened,” she said.

“Previously, interest rates were low and banks had money to on-lend. It is a very different envi­ronment now. This makes capital management very important with an illiquid asset like property.”

Looking back for answers

According to Atchison, with the benefit of hindsight, three key factors were behind the sector’s decline. The first was the com­position of the distributions paid to investors.

“The distributions paid by A-REITs was not just rental income … yields were being supported by considerable dis­tribution of trust capital,” he said. This created a “misunder­standing” and “gave a false impression” of how some of the trusts were performing.

Higgins agreed capital return became an issue.

“It was good when things are going up, but now markets are suspicious of any debt, so it is a very big negative impact.”

The second problem came with the new activities many A-REITs moved into, such as prop­erty development and funds management.

As Higgins explained: “Tradi­tionally they were ‘landowners’, but in the past five years they have moved away from being collectors of income streams to having high gearing and getting into foreign markets — even though this was good for diver­sification.”

Before the market turned, these activities were viewed as positives for a sector often seen as stuffy and old-fashioned.

“Commentators had been very critical about LPTs being too conservative, but now they are being hit for the changes they made,” Higgins said. “It is one of those circumstances that hap­pens when the cycle turns.”

Atchison agreed views have turned sharply.

“These ‘extra-activities’ were priced as significant price/earn­ings (P/Es) multiples by the mar­ket. They were given premium pricing and that was a flawed approach,” he said. “There is now no value being given to those things, so that is just as extreme.”

Many of the woes that have befallen A-REITs are the result of these changes, according to Dullahide.

“LPTs are not just about prop­erty exposure; they have fund management, property and prop­erty development components,” she said.

“There are problems due to a recognition that capital manage­ment capacity is very critical … It is tied to the global credit issue, as this increasingly raised questions about the funds management capability of some vehicles.”

Dullahide believes negative sentiment has swept everything before it.

“Investor sentiment has come into play. The volatility in the sec­tor is being driven by sentiment.”

The final issue behind the sec­tor’s decline relates to the complex financial structuring that trans­formed what were simple vehicles based on rental income streams.

“They became convoluted, financially engineered structures which only got away because it was a bull market,” Atchison noted.

Investors failed to appreciate the scope of the structural changes occurring in the A-REIT sector, according to Dullahide.

“They are seen as a more tra­ditional asset class, but this per­ception is not in line with the changed structures.”

How long will it last?

It seems the outlook for listed property is unlikely to change any time soon.

When Lonsec released its annual Australian Property Secu­rities Fund Sector report in July, it noted the bad news “is likely to continue in the short to medium term, reflecting tough conditions (wider credit spreads) and A-REIT structural issues (financial engineering and unsustainably high payout ratios.

Atchison believes the worst is over, but like most experts has no idea when conditions will change.

“The pricing says cap rates are going to blow up, but the market evidence is that is not going to happen,” he said.

His firm tracked credit spreads as the listed market collapsed and is now starting to detect some positive signs. According to Atchison, spreads peaked around the time of the Bears Stern’s collapse before con­tracting and then blowing out again during the June/July period. However, they did not reach their previous peak.

“We see this as a measure of risk aversion, and credit spreads are giving an indication that investors are willing to start tak­ing some risks again.”

Higgins expects the volatility to continue for some time.

“I would like to think we have seen the bottom, but there are too many unknowns — especial­ly in the US.”

Dullahide agrees the high level of market volatility makes it diffi­cult to predict future performance.

“There is so much uncertain­ty about … but the opportunity for upside is there.”

In a recent interview on ABC-TV, long-time market player and Mirvac Group managing direc­tor Greg Paramour was a bit more forthcoming.

"We’re at the dark side of the moon, we’ve got to get round the other side and that will take some time, and these cycles nor­mally last, you know, one to five years.”

When the market does recov­er, Higgins believes this rout will be seen as fairly normal.

“When you take the really long-term view, this is just part of the cycle.”

Not a sunny outlook

When it comes to investment returns, sentiment remains pret­ty gloomy.

While the Lonsec report noted that on a selective basis there was some value, it remained wary.

“Investors should remain cau­tious and focus on the ‘plain vanilla’ property trusts that have a bias to Australian property, high occupancy, mostly rental income, reasonable levels of gear­ing and manageable lease and debt maturity profiles.”

Most experts agree there are buying opportunities.

“The market is now offering good opportunities in selected areas as you can buy assets at a discount to their value,” Atchi­son said.

"However, you need to ensure there are no remnants of the pre­vious problems remaining before investing."

Improvements in the gearing levels of A-REITs are also a positive.

“Most of the A-REITs are sell­ing properties and paying down debt, so there are decreasing debt levels,” noted Atchison.

Higgins agreed opportunities are emerging.

“Property is an illiquid asset class that can be traded in a liq­uid market, so there are big opportunities for mis-pricing. We see some significant opportuni­ties if you are prepared to com­mit funds for the long-term.”

When it comes to property more generally, Higgins believes demand for real estate in Aus­tralia will remain strong.

“There will always be demand for real estate. Unlike equities it is very tangible, not ephemeral.”

He believes the current situa­tion is unlike the property crash in the early 1990s, which was due to money flooding out of the share market and a subsequent building boom.

“This time we do not have the supply overhand and vacancy rates are quite good.”

While the media is reporting bil­lions in property flooding the mar­ket, Dullahide believes Australia will be spared the oversupply problems occurring overseas.

“Although we are given pause by reports of huge amounts of property coming onto the mar­ket, it may not all actually occur,” she said.

Atchison believes the broad market fundamentals are rea­sonable. He sees rents in the office sector as quite strong, while the fundamentals of the retail sector remain reasonably positive, despite the slowing eco­nomic growth rate.

When it comes to industrial property, the supply/demand bal­ance is less favourable, so while rents may rise, Atchison believes it is likely to be less than in other sectors.

Dullahide agreed with this view. “On the whole, I’m posi­tive on the outlook.”

However, she feels the proper­ty market may still see a mild correction.

“In this environment, a cap rate correction of some sort is expected — probably 25 basis points.”

There is also concern about what the collapse in listed prop­erty means for the unlisted sector.

Higgins is cautious about the unlisted sector, particularly given the high prices paid for some properties in recent years.

“The unlisted sector needs to be careful as it has its own prob­lems. It had yield compression of over 3 per cent over the past cou­ple of years.”

The level of gearing in many unlisted trusts has increased to top up returns to investors, Hig­gins noted.

“In some trusts, up to 40 per cent of the return was return of capital, and now valuations are starting to unwind there could be problems.”

As this was a factor in the col­lapse of the listed market, Atchi­son believes it is vital for advis­ers to review the composition of distributions in clients’ unlisted property investments.

“You need to look through to determine if the rental yield is being supplemented by capital distributions.”

Atchison is more bearish on listed than unlisted property. “There is a lot of discussion that the listed market is implying cap rates on unlisted are going out a long way. We believe they will a bit, but nowhere near as high as the increases in the listed mar­ket,” he said.

“The listed market got very overvalued but now it is being priced back to sensible levels.”

The timing lag in property val­uations for the unlisted sector rais­es some concerns for Higgins and he said it was becoming “increas­ingly common for unit prices to slide in the unlisted sector”.

Advice for financial planners

When it comes to listed prop­erty, the advice is clear.

“Planners need to ensure clients understand their property invest­ments and what they represent in their portfolio and to reassure them that they do not need to be concerned about short-term volatility,” Higgins said.

Dullahide also believes under­standing is vital.

“Advisers need to explain why the asset is in the portfolio and how it all fits together with the other assets … It is important to have a contextual conversation.”

For Atchison, it is all about why the allocation was made in the first place.

“It is important to remember that the income component is still there. It was overstated due to the capital distributions, but if an income stream was what you were investing for, then it remains relatively stable.”

Higgins agreed income is the heart of this asset class.

“Property is one-third growth and two-thirds income. In the past couple of years it changed to almost the reverse of that sit­uation and that is not an ongo­ing position.”

Advisers and investors also need to understand the various products, as some are property-backed vehicles, rather than actu­al property investments.

“Ensure you understand what you are invested in and what the timeframe for that investment is,” Higgins cautioned.

The redemption problems being experienced by several hybrid funds also need to be con­sidered by advisers.

“The message is the manager must have a well developed liq­uidity policy to avoid problems,” Atchison said.

The main tip for advisers and clients, however, is not to panic.

“The adviser needs to find out what the investor’s con­cerns are and address those — whether it is liquidity, price declines or volatility,” Dul­lahide said.

“Clients and advisers need to understand that property does have volatility associated with it. It is not the time to exit the sec­tor and it may be time to recon­sider the balance of investments in the portfolio.”

As a listed asset sometimes it will become overvalued and some­times it will be undervalued.

“A-REITs are listed, so that provides liquidity, but part of the price of liquidity is high volatil­ity. It reinforces the long-term focus that you need to take with investing in the listed market,” Atchison cautioned.