The implosion that occurred in the value of the listed Centro vehicles appears to reflect the combustible interaction of an operationally and financially leveraged structure with a 'once in a lifetime' event. However one apportions blame, the destruction of value has been massive, immediate and probably irreversible.
The fact that the responsible entity for Centro’s two unlisted funds has had to suspend redemptions – the first time this has occurred since the unlisted property trust sector froze redemptions in the early 1990s – and that Centro Retail Trust will not make a distribution is an indicator of the stress the group is under. That was reflected dramatically in the $5 billion or so that has been wiped off the market value of Centro's two flagship listed entities.
Centro’s predicament is born out of an understandable misjudgment. It assumed that markets that had functioned with increasing depth and efficiency would continue to function. For several decades the trend in financial markets has been towards disintermediation, with the markets providing corporate funding and the banks shifting towards more of a facilitator’s role.
Centro has been aggressively expanding offshore. In less than two years its funds under management have grown from just under $10 billion to $26.6 billion. The two big acquisitions that helped propel Centro into a major player in the US retail property sector were last year’s $4.3 billion acquisition of the Heritage Property Group and February's $5 billion New Plan Excel Realty deal.
For those acquisitions Centro arranged relatively short-term funding, confident it could subsequently refinance them on better terms. Then it got distracted by detail while bedding the deals down. In the meantime it was running gearing levels outside its normal target range – in its terms the "see through” gearing was about 48 per cent compared with the 35 per cent to 40 per cent range it preferred.
When it went to the market in August – some months after the sub-prime crisis started to develop and not long after it had successfully raised $US300 million from the mortgage-backed securities market – it received reassuring responses. It thought it could refinance the remaining debt in the mortgage-backed securities markets. Even a week or two ago it thought the banking system would step in to provide the funding.
What it discovered – much like the RAMS Home Loan group – is that trillion dollar markets that had functioned well for decades had seized up. Not only has the market for mortgage-backed securities been frozen but the commercial paper market has also been affected by the fear pervading credit markets generally, resulting in a massive call on standby lines of credit and therefore a big drain on bank balance sheets. That has been compounded as banks have been forced to bring what used to be off-balance-sheet or ‘conduit’ vehicles back onto their balance sheets.
Until they have a better understanding of where the sub-prime losses will eventually end up, banks are unwilling to lend even to other banks. This was the environment in which Centro was begging for funds. It couldn’t get them at any price. As it says, it has been the victim of the global liquidity crunch.
The impact has, however, been magnified by its own structure. Centro was structured to leverage its capital base and to expand using ‘other peoples’ money’ and debt. The structure is quite complex and opaque but essentially it has tiered equity and debt, with the property-owning vehicles at the bottom generating fee income for Centro Properties at the top. It was a structure that leveraged the impact of the long-running bullmarket for listed property entities and allowed Centro itself to continually churn or ‘recycle’ capital to support its expansion.
Much of Centro’s own market value was tied up in the capitalisation of annuity income streams whose growth was reliant on that expansion continuing – which explains why it was savaged by the market.
There is nothing wrong with the group's underlying property assets – retail centres with low vacancy levels and strong income growth. But then there was little wrong with the RAMS mortgage portfolio, other than the fact its funding structure was too short term at the very point when markets began to shut down.
Centro’s options are all unpalatable. It could raise equity at prices that are so distressed existing equity holders would effectively be wiped out. It could sell some of the Centro interests in the downstream vehicles to raise cash – again at distressed prices. Or it could sell the underlying properties. It would need to get something close to net asset values for the properties to avoid crystallising losses and exacerbating its position.
None of those options are particularly palatable. Westfield, still sitting on most of the $3 billion of capital it raised so presciently earlier this year, might see an opportunity to both inject some stability into the sector and prise loose some key assets by making Centro an offer it can’t refuse.
With the clock ticking – Centro has only until the extended deadline of February 15 to refinance the debt – there is an unavoidable degree of desperation to its plight.
Centro has probably been the most heavily engineered of the local property groups but it isn’t the only one that has tried to soup up its returns with leverage and operational risk. That doesn’t appear to have brought it undone but it does appear to be a contributing factor to the extent that its value has been decimated.
The market is going to be very leery of any entity that has both leverage and any significant refinancing event occurring while credit markets remain dysfunctional.