Listed property: Out of the abyss

After staring into the abyss of a complete financial meltdown, investors are looking to a brighter future — and listed property may be part of the answer.

From their peak in 2007 to the market bottom in March 2009, Australian real estate investment trusts (AREITs) fell 79 per cent, leaving many investors and financial advisers wondering if this was the end of the line for a sector that had been a key component of their portfolios.

The damage has been painful. Figures compiled by Bloomberg indicate the entities comprising the S&P/ASX200 AREIT Index had combined losses of $19.5 billion and write downs of $21.7 billion in the year to June 30, 2009.

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Despite the losses, survivors are beginning to emerge and the market is starting to look on AREITs a little more kindly.

The S&P/ASX200 AREIT Index has risen 60 per cent since its low point in March, but it still remains 66 per cent below its February 2007 peak.

A similar second quarter rebound has occurred in global REITs (GREITs), with the FTSE EPRA/NAREIT Global Developed Real Estate Index posting a 31 per cent total return.

According to US-based CBRE Investors, global REITs delivered a first-half 2009 total return of 4 per cent, leaving the 12-month total return sitting at minus 33.7 per cent.

According to Atchison Consulting managing director Ken Atchison, the pattern of boom and bust in the REIT market was a global phenomenon. “There was a bull market in all REIT markets. Their performance has been broadly similar on the upside in the bull market and similar on the downside in the bear market,” he said.

He put much of the negative performance of AREITs down to their “massive overpricing” in the run-up to the market’s peak in 2007. “They got to premiums that were extremely high, so now we have come back from that,” he said.

Invesco Australia chief executive Mick O’Brien agrees the massive sell-off is starting to reverse.

“Sentiment last year was to avoid anything with gearing and property risk, which led to a significant mark down as the market was concerned about refinancing risk. In the past few months we have seen a reversal of the momentum of last year,” he said.

Turning the corner?

While the AREIT market has started its slow crawl back from the brink, few experts are overly optimistic about the short term. Rather than seeing a return to the good old days, it is more a case of things being “less bad”.

Atchison believes the current recovery in AREIT prices is more “a repricing to eliminate Armageddon”.

“The recovery has been very strong but it is still way below the peak of 18 months ago. There is still a long way to go,” he said.

Adviser Edge head of prop-erty research Louis Christopher agreed conditions have improved compared to this time last year, but points out they remain far from normal.

“We have had a pick up in the sector since March and that rally means the large discount to NTA [net tangible assets] has been reducing from over 50 per cent to now being back to 20 per cent to 30 per cent,” he said.

“Historically, AREITs traded at a premium to NTA, so being at a discount is a most unusual situation.”

Christopher believes the situation is unlikely to change soon. “Over time the discount will continue to narrow, but I cannot see a justification for them to trade at a premium to NTA unless there is a massive boom in commercial property,” he said.

He believes there are still significant hurdles — such as increasing vacancy rates — yet to be faced.

“In terms of outlook, there is a light at the end of the tunnel, but there are still key challenges going forward,” Christopher said.

The positive outlook for the Australian economy, growing business optimism and lower than expected unemployment numbers are helping the prospects for property markets, according to O’Brien.

“It seems the Australian economy is going to be reasonably robust through this period with less unemployment than expected. Unemployment is a significant driver of the office and retail property sector, so it seems we are not going to see major rental gaps in these property markets,” he said.

Atchison agreed the outlook for rents is fair. “Rents are subdued but they are still growing,” he said.

Global economic gloom

This contrasts with the outlook for major international economies.

“The underlying property fundamentals are less weak [in Australia] than in the US and Continental Europe,” Atchison said.

“There is an oversupply of property in New York, London and the financial centres and rents are weaker.”

Steve Carroll, co-chief investment officer for the CBRE Investors Global Real Estate Securities fund (which is available locally via Advance Asset Management’s Global Property Fund), is also cautious.

In a recent client letter he wrote: “Despite a more optimistic outlook, we believe it will take some time until the sector materially emerges from the

current downturn as we forecast property-level operating weakness in the US and a number of other markets to continue through at least 2010.”

The one bright spot has been the willingness of investors to help recapitalise the weakened REIT market.

Carroll pointed out around US$43 billion in equity had been raised by REITs so far in 2009, with AREITs having been responsible for around 20 per cent of this figure.

“This is a huge recapitalisation of the sector and a paying down of debt,” Atchison notes.

While the massive recapitalisation by AREITs over the past 18 months has helped restore investor confidence, difficulties remain.

“There are still financing challenges for the sector as banks are reluctant to lend,” Christopher said.

“We are seeing tentative signs of financing loosening up, but the question is whether the banking sector has the financing available to meet the demand. The financial supply issues are not yet clarified.”

Finding money for future activities is also likely to keep growth prospects subdued.

“The banks are now requiring high hurdle rates of pre-sales before providing financing for development,” Christopher said.

“This may explain some of the discounting [to NTA] we are still seeing in the sector.”

Challenges still ahead

Another positive for the AREIT market is that fears of a major property price crash seem to have dispersed.

“You are not seeing fire sale prices,” Atchison said. “The June quarter has proved to be the low point in the pricing of real assets. With cap rates, prices are not going to get cheaper than now, except for poor quality properties.”

O’Brien agreed concern about prices appears to be dissolving.

“We have not seen many sales of major properties, so it is difficult to really finetune thinking about valuations, but I believe there will not be a lot of significant sales over the next 12 to 18 months,” he said.

“Valuations are reasonably fair and more reasonable in REITs than in the unlisted market as it is still lagging.”

While naked fear may be in retreat, investors remain wary — and with a much greater appreciation for risk.

“There is now more discernment in the market,” Atchison said. “Before they [AREITs] were priced as if risk did not matter.”

The renewed focus on risk is leading analysts to question the quality of rental flows in some AREITs.

“The issue is some of them have poor quality assets in their portfolio. This is part of the reason some trusts are not recovering. When the market looks at the lease arrangements, it is concerned,” Atchison explained.

Their near death experience seems to be encouraging AREITs to take a back to basics approach.

Michael Doble, chief executive of real estate securities at APN Property Group, believes AREITs are returning to their origins.

“The makeover the AREIT sector has undergone in the last 12 months is delivering a positive outcome. The sector has been cleansed of the excesses of the past. Risk is out.”

O’Brien also believe REITs have learnt their lesson. “The REITs saw what happened with financially engineered structure like Centro and this is leading to them getting back to basics,” he said.

According to Doble, this will mean lower returns as REITs are “reshaping their business to reflect their original intended form”.

“Returns are reverting to what they should always have been — they will be lower and increase at a steadier rate,” he said.

“Longer term, we can expect returns of around 8 per cent to 11 per cent per annum from AREITs … the sector is on a more sustainable footing going forward.”

While Christopher agreed the sector is changing, he believes REITs will not all abandon their stapled structures and return to simple rental income vehicles.

“The structures are likely to remain intact, but they are likely to return to their core business,” he said.

If fact, some of the shift away from financial engineering and property development is being forced on AREITs by economic conditions.

“They can’t get debt finance at the moment, so it is very difficult to do development even if they want to,” Atchison said. “The cost of capital is going to be a lot higher, so REITs are being squeezed out of these activities. Market pricing is dictating a change to go back to basics.”

Disappearing dividend

AREITs are also shifting in relation to the income streams they provide. Far from being the source of strong dividends, most AREITs have cut or even eliminated their dividends.

According to O’Brien, this reflects the different market situation.

“What you are seeing is REITs rebuilding their equity position and one way of doing this is to raise capital by reducing dividends. They are also experiencing reduced levels of income,” he said.

O’Brien is optimistic dividends will eventually return to a more normal situation. “I expect to see some gradual increases in income over time.”

Christopher is not so sure. “The situation is changing as many offerings were paying out 100 per cent plus distributions and we are not likely to return to that situation. For the foreseeable future, dividends are likely to be up to 70 per cent,” he said.

While this means advisers may need to rethink their use of REITs as a source of income for clients, Christopher believes the change needs to be kept in perspective.

“It is important to remember that even with the cuts in distributions you are still getting a good yield. Current pricing represents a way of buying good yield.”

Dr Shane Oliver, head of investment strategy at AMP Capital Investors, believes listed property securities offer very attractive distribution yields.

“While distributions are still being cut and this exaggerates the yield … they will probably settle around 10 per cent at current share prices,” he said.

“This compares with an average 7.1 per cent or so yield now offered by directly held Australian non-residential property and a 4 per cent to 5 per cent gross yield offered by directly-held residential property. A 10 per cent distribution yield is well above anything seen in the last decade and should help underpin very solid medium-term returns from Australian-listed property securities.”

Just as the size of dividends has changed, so has their composition. In recent years, some REITs were topping up their dividends with capital repayments.

“A disturbing aspect of the recent past was the lack of transparency in AREITs,” Atchison said.

“In the future we will see greater focus on the transparency of the structures and the transparency of the payments or they will be harshly punished by the market.”

Time to take the plunge?

While some investment experts are cautious, others believe the current pricing of AREITs makes them a strong buying opportunity.

In a recent note to clients, Southern Cross Equities director Charlie Aitken said the sector of the Australian equity market where investors were most likely to double their money over the next five years was in AREITs.

He said they were “a strong buy on a one minute, one week, one month, one year, two year and five year view. This is the place to find alpha. After the meltdown comes the melt up.”

Aitken’s very bullish stance is because “the discounts to NTA you see today will evaporate over the next few years and that, combined with 8 per cent plus distribution yields should generate us minimum +50 per cent return as investors return to the space”.

However, not everyone is ready to give the sector such a glowing endorsement.

Christopher agrees the sector is worth a look, but remains cautious.

“We were underweight REITs until April and then we went to a neutral position. We did that then as many REITs were priced for bankruptcy, but that is very unlikely. We still see some opportunities as the discount to NTA narrows,” he said. “There is still some upside from here, but not enough to go overweight the sector.”

Atchison agreed the sector is looking more appealing. “Now the pricing level is reflecting a fairly subdued outlook and that makes it a reasonably attractive investment,” he said. “AREITs are reasonable value if you ensure you are buying quality.”

According to O’Brien, the prospects for GREITs are also looking up. “The outlook is starting to be more positive. There has been a levelling out in the economic outlook so it is more positive than last year.”

He feels the best opportunities in the near future will be in the growing Asian REIT market, as this is where most economic activity is likely to occur over the next few years.

“We will see the best growth potential come out of Asian markets, especially the Chinese markets,” O’Brien said.

“The expansion of the Asian economies offers development opportunities that are unavailable in AREITs.”

GREITs are offering dividend yields of about 5.5 per cent, he said.

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