A-REITs: The coming carbon split

PORTFOLIO POINT: A-REITs are coming back into vogue, after the sector almost self-destructed under weighty debt loads in recent times – only now, environmental factors must be considered.

Throughout the last 12 months, as the debate over a carbon tax raged in parliament and across the media, most attention was focussed on the energy and resources sector. Now, with the legislation passed and the tax about to become a reality on July 1, the spotlight is turning to the commercial property market – and that means property stocks and A-REITs.

The first inkling of just how potent a factor the carbon tax might become surfaced just days ago, when Prime Minister Julia Gillard was prompted to explain why Westfield was moving to pass on higher charges following the carbon tax.

Westfield responded quickly to the new legislation when it announced to 11,885 retailers across Australia that it would impose a “carbon or greenhouse gas emission-related charge and recover the same from the lessee at cost".

In response, the Prime Minister said such 'charge clauses’ had been in place within the property sector for some time, but the exchange raised eyebrows across the investment industry, especially when the Shopping Centre Council of Australia confirmed rising electricity prices would indeed push tenancy costs higher.

The incident signalled the first skirmish in a new era, where all commercial buildings will be assessed on their environment-related costs, and polluting buildings are going to become more costly to run, while greener buildings are going to become less expensive.

In turn, property companies and A-REITS will split into the well-placed greener variety and the expensive-to-run, low-rated portfolios. Longer term, the split will not just affect rentals, but valuations themselves.

What does it all mean for the investor?

As real estate investment trusts (REITs) get their debt levels under control and slink back to Australia from their foreign misadventures, A-REITS have returned to the mainstream as legitimate investment options – the property index outperformed the ASX 200 in the year to March 21 by 4.59%.

But as this new era of A-REIT investing commences, 'sustainability’ is high on the agenda. Property researcher IPD’s Green Property Index already shows that buildings with high green-energy ratings are more likely to deliver better investment returns than those without.

IPD managing director Anthony De Francesco says the company’s analysis – of 482 buildings owned by 32 listed and non-listed office funds – shows the capital return of buildings with very high green ratings for the year to December 31, 2011 was better than that of the sector as a whole.

Just so you know, there are two ratings systems used in Australia: the Green Star and NABERS (National Australian Built Environment Rating System), both of which go to six stars and measure building features, such as efficiency in energy and water use.)

Source GBCA & IPD Research

(* PKF suggests the outperformance of 4-star rated buildings compared to 5- and 6-star ones may also be due to lower construction costs (meaning the recovery period is shorter) or because of a more robust tenancy profile when markets are sluggish)

Source: NABERS & IPD Research

(* The buildings with ratings of 4 or higher also have expected higher capital growth)

As signalled by the two charts above, a split A-REIT market is emerging – those that own the desirable, low-energy consuming, well-designed buildings, and those that are stuck with older properties that are difficult or almost-impossible to fully bring up to an energy-efficient standard, and hence cost more to run while earning less in rent.

So which funds will win and which will lose? Winners are going to include funds such as GPT Group, DEXUS, Stockland and Investa, while the losers will be owners of older, heritage-listed buildings, such as Commonwealth Property Office Fund, which have restrictions on what can be modified, and funds such as AMP, which has a relatively low overall NABERS energy rating (compared to its peers) of 3.13 on its total office property holdings (based on the buildings listed on the NABERS website), and owns buildings constructed in the 19070s and 1980s such as Collins Place in Melbourne and the three properties on Young Street, Sydney, that don’t have ratings.. AMP wasn’t able to provide a comment by the time of publication.

-NABERS Ratings for A-REITS
REIT	NABERS average energy rating *	Number of office properties listed on NABERS website
GPT	5.11	19
Charter Hall Office Fund	4.55	18
Brookfield	3.86	14
Investa	3.75	47
Stockland	3.68	18
DEXUS	3.63	37
Abacus Property	3.50	6
Mirvac	3.31	26
Colonial First State	3.24	24
AMP	3.13	40
Challenger	2.95	12
Aspen	2.30	5
* Average ratings of all the buildings owned under the parent company; may be jointly owned. Average rating is for those buildings listed on the NABERS website only.

DEXUS chief operating officer Tanya Cox says the introduction of the carbon tax on July 1 is just one part of the need for A-REITs to have a high-quality portfolio of properties.

Cox says rising electricity and construction materials prices, top-end corporate demand, and the mandate for government departments to work in buildings with no less than a 4.5 star rating means A-REITs that saw the currents early are going to be at the forefront of the sector.

“There are some government tenancies, for instance, in buildings that may not have been upgraded and what that means is that they will be forced to leave when their lease expires and they will have to go and look for a higher-graded building. That’s why even though the capex we had to spend – the $40m commitment – financially appears to have no direct return. Ultimately, we know that the types of tenants that we’re targeting will absolutely move from buildings that have a lower NABERS rating to a DEXUS building.”

Research from the Australian Property Institute (API) in December last year, and from IPD this month, supports the theory that A-REITs whose sustainable buildings are up and running now are starting to see the returns they suspected would come.

The API study found that buildings with a NABERS 5-star energy rating delivered a 9% market premium in value, and a Green Star rating delivered a 12% premium.

Different markets also delivered different results, with the Canberra office market doing extremely well from the government move to only operate out of 4.5-starred premises, with unrated and lower rated buildings being discounted by up to 13%, while 5-star properties got a 21% green premium. Sydney rents saw the greatest rental premium for a green rating, standing at 3-5%, while landlords with unrated buildings can look forward to a 9% discount in their rental take.

Writing in a recent edition of the Asia Pacific REIT Monitor, PKF’s Ed Psalits said: “Most 'whale’ and 'anchor’ tenants are demanding six star rated (basically new) building'¦This is likely to impact on the rental achieved for older style, less energy efficient buildings. The costs of refurbishing older buildings will increase where energy efficiency as well as look becomes an increasingly important selling point. Finally, any changes in potential rents and the running costs of buildings will flow through to valuations and ultimately financing costs.”

The question now for investors is whether the other factors facing the A-REIT market – a weak retail environment, the postponement for 12 months of decreases in incentives in the key Sydney and Melbourne office markets, and average gearing of 42% across the sector, according to PKF – will outweigh the benefits of a fund’s individual assets and warrant that spending on refits and new buildings.

One thing is clear – even with this new distinguishing feature, A-REITS remain highly correlated to sharemarket performance rather than to the steadier returns of their underlying assets.

The PKF report says several factors will make A-REITs more attractive investments, such as industry consolidation and proof that businesses are simplifying and reducing debt. But it’ll be the ones spending the money now on sustainable buildings that are the ones to watch, says DEXUS’ Cox, because those that don’t won’t be able to continue to compete in the tier-one arena.