The future of REITS in Australia

Australians have received countless blessings from their US cousins, including the iPod, KFC and former president Bush, showing that US voters have an interesting sense of humour. But I still prefer referring to the REIT (real estate investment trust) sector as the listed property sector, despite our relatively recent move to emulate the 'REIT' acronym commonly used in the US.

I attended a presentation on 'The future of REITs in Australia' on 27 May. The three speakers were David Harrison, joint managing director of Charter Hall Group, Simon Shakesheff, managing director of Real Estate Group Merrill Lynch, and the highlight of the evening, Andrew Parsons, managing director of Resolution Capital.

Smart money

I was particularly interested to hear Harrison speak, as I hadn't eyeballed a Charter Hall executive prior to the presentation. Also, a year ago shopping centre billionaire John Gandel (who we consider some very smart money) invested a relatively large sum in Charter Hall, which recently acquired the former Macquarie Office and Macquarie CountryWide property trusts. So we've been watching the group's progress with a keen eye.

In contrast to what current market prices suggest, Harrison expects the REIT sector to return 20% to 35% over the next two years. Rental growth and a cyclical recovery in property values would account for 10% to 15%, and the balance would arrive as listed market prices increased.

This is because the majority of REITs in Australia are currently trading at a discount to their reported net tangible asset (NTA) values, and Harrison expects a wave of higher property valuations to emerge throughout the remainder of 2010 and beyond. The early signs are already evident in recent valuation updates provided by Commonwealth Property Office Fund and CFS Retail Property Trust, for example.

Australia's recovery lag

Somewhat to my surprise, Shakesheff, who followed Harrison, released a slide that showed the 52.3% recovery in the Australian REIT sector from the March 2009 low had lagged every other major market, and paled against the 122% return in the US. Though the fact that Westfield dominates the Australian REIT index plays a large role in this discrepancy. Westfield's position in the index has increased substantially following the downturn, and having not fallen as far as most of its rivals, it hasn't bounced back as strongly.

While Harrison focused on total returns (from higher property values and distributions), Shakesheff suggested that Australian investors are more interested in yield, and that discounts to NTA would likely persist until distributions kicked up. Shakesheff's forecast distribution yield for the sector in 2011 is 6.7%, which would drop to 5.4% if the gap between listed market prices and reported NTA values closed. Paltry yields are largely why The Intelligent Investor has been selective with its recommendations in the sector.

Shakesheff blamed the short duration of loans for the sector's collapse in 2008/09. REITs in other parts of the world were apparently better prepared as they weren't hitched to relatively short term bank debt (nervous bankers tend to want it back when times get tough).

However, Parsons retorted that it was the onerous covenants on the bank debt that was the major problem, not the duration of the loans. But given credit markets are only beginning to emerge from a deep freeze and Australia is stuck with a highly undeveloped corporate debt market compared to the US, it's unlikely that the sector's Achilles heel will be overcome any time soon.

A property value investor

I was pleasantly surprised to learn that Parsons was a value investor; if not in name, certainly in practice. Parsons pointed out that the Australian REIT sector suffers from a lack of diversification, due to Westfield's dominance and a scarcity of disciplined managers. Though Parsons believed there were only a few good operators in Australia, he nominated the Lowys of Westfield as one of them.

Parsons lamented that Australian property managers were undisciplined and tried to be everything to all investors. For example, managers have swung with the latest fashion, which has at times included preferences for high yields, growth, development capability, diversification and specialisation. The fad for chasing what is hot explains why the sector has produced a lousy trough-to-trough annual return of around 5% between 1992 and 2009.

Parsons was also prepared to name some global stocks that boasted shrewd operators. The list included UK group Shaftesbury, French group Silic, European group Unibail-Rodamco and US groups Federal Realty and Boston Properties. Parsons said there were only around 80 REITs in his fund's global universe worth following.

Though I enjoyed the presentation more than I expected thanks to Parsons' entertaining mix of candour and humour, the sad fact remains that the recent downturn is unlikely to have any lasting impact on management attitudes.

Most of the managers that failed abysmally in their role as stewards of capital are still in charge and, as you might expect, they don't have a substantial amount of their own money on the line. To the detriment of investors, most property groups will continue to be run as products rather than investments that create value for securityholders over the long term. Buyer beware.

If you'd like to share any thoughts on the REIT sector, the unlisted property sector or if you have witnessed evidence of improving commercial property fundamentals, please leave your comments below.