GPT's Daring New Clothes

Background, by Eureka Report editor James Kirby: Once regarded as the most conservative of property landlords, GPT has changed beyond recognition under a new regime led by Nic Lyons. In today’s video, Lyons tells Robert Gottliebsen* the venerable LPT had to lift its risk levels to match the LPT earnings now demanded by investors.

Lyons explains that a key element of the group’s expansion strategy is a joint venture with the investment bank Babcock & Brown. Lyons clearly hopes the investment bank will create opportunities that allow GPT to compete in deal-making alongside higher-priced rivals such as Centro Properties Group and Stockland.

But Lyons is quick to point out that a very conservative management style remains a core principle at GPT, which hedges against interest rate risk. The hedging strategy will certainly appeal to yield-chasing investors as the market digests yet another interest lift in the US market and renewed speculation that the Reserve Bank may also be about to lift Australian rates.

The interview

Robert Gottliebsen: Why did GPT need to take a higher risk profile?

Nic Lyons: Well, GPT has changed because the listed property trust market in which we operate has changed. Investors are now demanding a higher level of earnings growth that really can’t be generated out of pure core property, which is what GPT used to do. As a consequence we’ve sought to expand GPT’s range of activities, including a joint venture with Babcock & Brown, to lift our return on equity to meet those market requirements. However, we believe we’re doing so by also managing that risk to ensure that we still remain true to the original intent of GPT, which was to provide investors with a stable but growing income stream. It’s really a question of managing those new businesses to make sure that you’re not taking excessive risk and we believe we’re doing that.

Who are those investors who wanted higher returns?

There are a range of investors but one of our largest form of investors are property security funds. These are funds that invest in a range of property securities. They’re also superannuation and pension funds, and what’s happened is their return requirements have actually increased because they compare GPT to other vehicles like the Stocklands and Mirvacs, etc, which actually have a combination of core portfolios and operating activities.

The global joint venture with Babcock & Brown was GPT’s main higher-risk operation. What will it look like in two years and 2010?

The joint venture has really got two legs to it. The first is to create an investment portfolio in markets that GPT previously hadn’t invested in and that’s primarily Europe and to a lesser degree the US. We’re endeavouring to invest $5.5 billion by the end of this year. We updated the market in April and at that point we had invested $3.9 billion and we’re very confident that we’ll be fully invested by the end of December 2006. The second leg of the strategy is to then, once we aggregate these portfolios, is to create a funds management business by spinning off these portfolios into separate vehicles, which the joint venture will then manage. So in two years’ time I would expect that the joint venture will have a combination of a core portfolio of assets that it’s earning investment returns from, together with a number of funds that it manages on behalf of external investors.

How has the European property market moved?

The European market has been very strong. I mean we started this strategy back in February of last year and we’ve seen significant yield compression, which has led to significant rise in values since then. That’s largely been driven by a significant inflow of capital from institutional investors who have also now seen that that market was probably underpriced relative to the returns that you can receive and relative to your cost of funding in Europe.

GPT has a large core Australian property portfolio. Will you change that as well?

The core Australian property portfolio is an important part of GPT’s return mix. It provides that very stable but growing income stream that underwrites the distributions to our investors, so we will always have a significant part of our balance sheet invested in the core portfolio. Even when the joint venture is fully invested, that will be 85% of our total assets. It will change over time in terms of we will continually look to improve the quality of the portfolio, improve the security of the income. We’ll also look at the opportunities of creating wholesale funds with our core portfolio and we’ll be co-investors with wholesale investors over time, but we’ll still have a very significant core portfolio because we want to remain true to the original intent of GPT: to provide a stable but growing income stream to our investors.

Will you sell part of your Australian core portfolio to joint venturers?

Yes, that makes a lot of sense to us because we are able to co-invest with like-minded investors that have very long-term investment horizons and they’re looking for pure property returns from core assets. In addition to that, it enables us to manage our balance sheet, creates a higher return on equity for GPT and creates a funds management business that is very valuable, providing we deliver the proper returns for those co-investors.

Those co-investors sound like the original GPT unit-holders.

Indeed, the traditional list of property trusts which were investing in pure core property were very much targeted by these core type property investors, but the listed property trust model has changed dramatically and as a consequence many of these investors are seeking to supplement their listed property trust exposures with investments in the pure property returns, which is what a wholesale fund actually is.

GPT therefore will have large trading profits. Will you distribute all those profits?

Yes, we’re anticipating that as we recycle capital in the joint venture that we should be able to realise some trading profits given that the European market has compressed in yields quite aggressively over the last 12 months or so. However, they will be quite lumpy and it’s not our intent to distribute them fully but to smooth distributions from those trading profits but the income that we earnt from the assets and the income from our core portfolio will always be distributed 100%.

What can go wrong with the strategy?

I think the major risk to probably just about any of the listed property trusts is really interest rates. That affects property trusts in a number of ways. Clearly, it affects the cost of borrowings that can impact on distributions. We believe we’ve managed that significantly with a very strong hedging policy targeting 75–100% interest rate hedges on our debt. The second impact of that, of course, is that rising interest rates impact things like retail sales and therefore the ability for tenants to pay rents; and, thirdly, they can impact the value of the property. Obviously, particularly if bond yields rise, the value of property can decrease and also the share price of GPT and other listed property trusts are generally affected by bond prices and therefore equity can rise as well. We think, though, that a lot of that is managed in GPT through very long maturities on our debt and in particular interest rates being hedged against increases.

How much do interest rates have to go up to affect property values?

Not a lot because, you know, if you look at it at the moment the risk-free rates are around the 6% mark and you’re getting 3% growth, so a half a percent increase in the risk-free rate means that you’ve got to get a higher return and sort of a 9.5% return out of property. So it would have an impact but, once again, nobody is looking at significant increases in interest rates. I think while we were expecting a modest increase over the next 12 months or so there’s not too many people that are actually predicting a very large increase in interest rates, and if interest rates do rise generally that means inflation is also rising, which means rents should also rise to compensate for that.

* Robert Gottliebsen is a national business commentator with The Australian.