A bubble in A-REITs?

Following a 39.7% return for A-REITs in the past year, Nathan Bell considers whether there is a bubble.

As far back as 2004 my colleague Gareth Brown was warning Intelligent Investor Share Advisor members that the listed property sector (now known as the A-REIT sector) was no longer a haven for conservative income investors.

Property valuations were high, debt levels were staggeringly high and simple trust structures had given way to complex beasts such as Goodman Group, which housed a typical property portfolio, a massive funds management business and a string of impregnable joint ventures and co-investments.

Share prices and distributions across the sector continued to increase dramatically up until 2008 when the gig was up. While the smart money had already sold out (Lang Walker had sold out to Mirvac), investors watched what was once Australia's best performing property trust, Centro Properties, essentially go broke after it bet the farm on a US expansion at the worst possible time.

While no trust was spared, those with overseas businesses where the GFC was at its most ferocious suffered the most. GPT's ill-fated deal with Babcock & Brown was exposed as the company's attempt to build a chiefly European funds management business collapsed.

While property values fell around the world, it was the sheer amount of debt that did the damage. Property in Australia hardly skipped a beat and continued to produce reliable distributions from stable rents.

Cromwell canary in the coalmine

'History does not repeat itself,' warned Mark Twain, 'but it does rhyme'.

Those looking at debt levels today won't find a property bubble, but chief executive of Cromwell Property Group Paul Weightman says it's there.

According to the AFR, Weightman blamed a 'wall of money' from yield hungry institutions for reducing yields without proper regard to fundamentals.

'We are seeing a different bubble developing this time compared to 2006. The usual driver of cap rate compression [higher property values] is rental growth – people willing to pay higher prices in anticipation of better returns in the future – and we are not seeing that this time. We have an enormous amount of capital from offshore looking to find a home in the Australian market but we have pretty poor underlying property fundamentals.'

Though office vacancy rates in Melbourne are expected to increase to 10% following a flood of new floor space, for example, investors searching for yields have been bidding up the prices of A-REITs. The sector, as measured by the S&P/ASX300 A-REIT Accumulation Index, has returned 39.7% over the past year alone.

'Sometimes the herd isn't right and we think we are entering another one of those periods. If it plays out like 1988, you will see prices bid up to the wazoo and a complete flop in property values.'

Weightman is planning to sell assets before the bubble bursts. 'Managing debt in an organisation like ours is more important than managing property. The last five years, the only real source of debt capital for us has been in the banks but we are at a point in the cycle now where we think the debt capital markets are starting to reawaken. We are seeing a very strong opportunity in the next couple of years to improve both the tenor and price of debt.'

Cromwell is also searching for the 'ugly duckling' mid-tier assets where prices were more rational.

This is one reason why Intelligent Investor Share Advisor had recommended buying Abacus Property Group at lower prices, though any collapse in top-tier property values could also significantly hurt owners of B-Grade properties, especially if vacancies increase.

The actions of Australian property moguls such as Frank Lowy, John Gandel and Lang Walker are instructive for contrarian investors. With the Lowy family recently selling out of Westfield Retail Trust and now a chief executive warning of a bubble – which is extremely rare – be careful you don't let low interest rates catch you reaching for yield.

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