A-REITs: Bad habits are back

The chase for yield has ensured strong capital returns for Australian real estate investment trusts (A-REITs) in recent times, with a 14% average return for the 2014 financial year. The relatively reliable and higher yield from A-REITs ensures that they are one of the key picks in any income-focused portfolio.

However, there are a number of factors suggesting that the recent strong capital gains may not be sustainable.

On a 12-month view bond yields remain the key risk to A-REIT pricing. Any tightening in the premium of A-REIT yields over bond rates would obviously reduce demand across the sector. With the increase in US interest rates only a matter of time, the market dynamic of focusing on yield without adequately considering the associated risks is likely to change.

Operationally there are signs of pre-GFC risky behaviour. Specifically, distributions that are not covered by free cash flow, and guidance for the growth of distributions above earnings guidance highlights the need for caution.

By way of example Mirvac has increased its 2014-15 distribution guidance above earnings-per-share (EPS) growth guidance. The distribution guidance of 9.2-9.4 cents per share represents growth of 2.3 – 4.5%, above EPS guidance of 1-3%.

Also, Charter Hall retail didn’t cover its distribution from either operational cash flow or free cash flow. The other list of offenders includes General Property Trust, Dexus, Stockland, Investa Office, Charter Hall Retail and CFS Retail.

While a one-off result where distributions are not covered by cash flow is no reason for panic, when it occurs over multiple periods it is clear evidence that the yield is not sustainable. The recent results with unsustainable payout ratios were not one-offs for most of the companies listed above.

Further, distributions that are funded by debt or asset sales are also not sustainable. Given the markets large focus on yield, there is also likely to be A-REITs which have held back maintenance spending in order to meet the market’s demand for yield.

Lessons from the GFC

In the easy money environment which prevailed prior to 2007, payout ratios consistently exceeded 100% of underlying earnings. Thanks to the staple structure many companies held investments in higher risk non-core activities outside their mainstream business of property investment.

This staple structure involves a trust holding the assets of one or more companies. Because of high gearing levels, when earnings came under pressure companies took on huge risk to meet their lofty payout ratios. As we know it ended in disaster, but most REITs have since done a great job to regain the confidence of the market.

Today in our low interest rate environment there are some signs of companies falling into the same pre-GFC traps. The average gearing level is now approaching 50%, higher than the usual safety barrier of 30%.

Separately, another key indicator in the sector – the degree to which the sector is trading in relation to its net tangible asset – is also throwing up some questions: In the pre-GFC peaks REITs reached a Net Tangible Asset (NTA) premium of up to 80%. In the difficult years which followed the crash the premiums turned to discounts, ranging down to a 20% discount to NTA in 2012. The current NTA premium of 15% is relatively high, though not at an extreme level just yet.

An A-REIT must pay out 90% of earnings to meet the tax-free status guideline. A payout ratio against reported earnings can be distorted by asset sales and other one off impacts. But the key thing to check for is if distributions are sustainable. To make this assessment you need to consider the ability to pay distributions from operating cash flow and the future earnings profile of the business as well as capex requirements.

Given the market’s current focus on yield without appropriately considering risk, extra care needs to be taken in assessing the ability of any REIT to maintain or grow its yield.

Sector Exposure

Caution is required with general statements as the risk needs to be assessed on a case-by-case basis. The other key factor to consider is the sector exposure.

There are well documented structural issues within the retail sector. Lower quality shopping centres may continue to struggle. With the structural issues of the shift to online, occupancy rates may be pressured (see Robert Gottliebsen’s article Lighten the retail property load). Major shopping centres such as Chadstone in Melbourne and Chatswood in Sydney will continually need to adapt to changing shopping and leisure preferences.

The office sector has been weak with high vacancy rates and has shown no signs of recovery. There has been increasing vacancies in most cities with new supply likely to be a structural drag for years to come. This is especially the case in Sydney where the excess capacity has got to such an extreme level that there is nine years of office space available from 2015.

Elsewhere, the residential sector has been the shining light, while the industrial sector has seen mixed conditions with weakness from the manufacturing sector offset by some larger transactions.

Follow the insiders

The recent events with the Lowy family and Westfield are also crucial in assessing the sector. A restructure in June saw Westfield’s domestic shopping centres spin off a new company called Scentre, enabling the Lowy family to focus on its overseas assets. Given that Westfield and the Lowy family are the biggest players in REITs, their exit from the domestic sector is significant and a likely early warning.

Summary

The average trailing yield for the 19 A-REITs in the ASX300 is just under 5%. There are several other smaller A-REITs trading on a higher yield due to the increased risk profile.

Our view is that the risks of capital declines with A-REITs don’t justify the extra 1-2% yield that can be achieved in comparison to a number of other quality ASX growth stocks. Further, as the REITs with greater than 90% payout ratio’s don’t pay tax, the yields are mostly not franked.

As a matter of interest the banks are also trading on a trailing yield of approximately 5%, and the ASX200 is also on 12-month trailing yield of approximately 4%.

A number of our small cap picks are also trading on reasonable yields. We are not necessarily recommending to sell A-REITs and switch into these other options, but rather we are suggesting that both the yield and also potential for capital growth need to be considered rather than blindly buying for income.