Losing trust in real estate

AUSTRALIANS fell in love with real estate investment trusts more than 40 years ago for their reliable, high income streams and steadiness in volatile times.

The trusts held prominent buildings in affluent parts of capital cities as well as thriving shopping centres in the suburbs. Their tenants, of the stature of Woolworths, Commonwealth Bank and Telstra, could always be relied on to pay the rent on time.

But now it seems the lover we thought we knew has changed. After a heartbreaking week of share price crashes, distribution cuts and earnings downgrades, the affair with property may be over.

"The old theory that REITs are a defensive investment when markets turn volatile hasn't rung very true this time," said Richard Morris, of Constellation Capital Management.

"There's been a lot of pressure from the market for the boring 'rent collectors' to get growth. This, coupled with rising property values and low debt cost, means we've seen a lot of ill-advised acquisitions and growth options which are now looking pretty problematic."

These ill-advised purchases have included hotels, marinas, aged-care homes, a dive into the funds management business and a grab-bag of shopping centres in North America that are now deserted thanks to the subprime crisis.

It came to a head on Monday when one of Australia's biggest and oldest trusts, GPT, sliced more than 25% off its earnings forecast for 2008-09 and told investors their distributions would be cut by a third.

Investors reacted by pushing down shares in GPT to an intraday low of $1.95, their lowest level since 1984. But who could blame them? Real estate investment trusts were traditionally about distributions. Threaten what for some investors is an important source of income, and you're in trouble.

"Investors need to be aware of where the property prices being paid were unrealistically high," said Angus Gluskie, managing director of White Funds Management.

There had been strong warnings before this week's implosion. Investment companies Centro and MFS had been unravelling under the weight of complex corporate structures and an inability to refinance short-term lending in the midst of the credit crunch.

Mirvac and Valad have cut their earnings estimates and distributions in the past month, citing reduced income from development and funds management. Westpac Office Trust did the same on Wednesday; Lend Lease and Stockland are tipped for downgrades.

The S&P/ASX 200 Real Estate Investment Trust Index is flailing - down nearly 40% over the year, compared with a fall of about 21% in the broader market.

This gap became apparent at the start of the year and has widened sharply since May.

So, what's going on with the property investment vehicle once considered "safe as houses"? According to Dougald Higgins, from ratings house PIR, the problem began with the push for trusts to stop being simple "rent collectors" and become sexier, more complex beasts.

"There has been a certain amount of brainwashing in the market in the past five years," Higgins says. "Pure property trusts were seen as boring. You had to diversify what you were up to . sex it up a bit."

This has involved "stapling" the trust structure to a corporation, which not only gives investors steady income from long-term commercial rent deals, but also allows them exposure to the riskier, more lucrative realm of property development, overseas investment and managed funds.

It was a fantastic combination in a time of low borrowing costs and rising property values, allowing for unprecedented price growth. In the 12 months to September 2007, capital returns grew faster than income in every property sector except for industrial.

With growth and income soaring, investors this week could almost be forgiven for wailing like Whitney Houston: "Didn't we almost have it all?" Many seem to have given up entirely on the sector - but have they overreacted?

Richard Morris says while some REITs have "lost the plot", they could still be a good way for small investors to get exposure to high-yielding commercial property - as long as it is domestic.

"The funds management model exemplified by Centro and Babcock & Brown is under a lot of pressure at the moment," Morris says. "These type of companies have really overdone it in terms of complexity, overseas exposure and lack of transparency."

Morris and other investment managers say the safest trusts are those that still operate as traditional rent collectors - Commonwealth Property Office Fund, Colonial First State Retail Property Trust and Westfield. Overseas investment has been maligned, and high-quality Australian property is preferred, but there could still be some value in trusts with exposure to countries such as Japan, Germany and Norway.

Some trusts with high gearing, including GPT, are at risk of breaching their loan covenants if the values of their properties fall any further and trigger a review by their bankers. Macquarie DDR and APN/UKA European Retail Trust have yet to sort out their predictions for 2008-09; both are geared over 50%.

Share prices that are well below net asset value have prompted the usual speculation about mergers and acquisitions, but that could be tempered by difficult borrowing conditions and an aversion to risk by nervous boards and managers.

Smaller trusts, and particularly retirement trusts, could be takeover targets. Jonathan Kriska, an analyst at Paterson Securities, said that, in the long term, exposure to retirement is "where you want to be".

"Anyone who's anyone in that space is trying to get a foothold in retirement," Kriska said, citing Lend Lease's recent plays at

FKP and Babcock & Brown Communities.

Retirement trusts would still suffer from the decline in residential property prices, with retirees reluctant to sell the family home and move into a retirement village. Most trusts also rely on "deferred management fees", paid when residents leave a home, for income, making revenue more difficult to predict. But Kriska said consolidation in the market and the weight of demographics would hold it in good stead.

"Long term we're undersupplied in the retirement sector. At the moment, there's still a lot of fragmentation. The deferred fee model works better in a broader base company structure where there are other revenue streams there to supplement the shortfall. Ones that try to wrap it up into a property trust and have to distribute all their earnings are going to struggle."

Whereas previously trusts had included property revaluations and development earnings in calculating their distributions, GPT has revised its policy to exclude development earnings and other resultant capital.

Michael Doble of APN Funds Management says the sector can redeem itself by following GPT's lead in re-evaluating its distributions policy.

Doble said others in a stronger financial position could also follow Westfield's lead and keep dividends steady even as earnings grew. Such short-term pain for investors would be better for the health of the market in the longer term, and investors should be prepared to wait.

"I wouldn't be selling at this point," he said. "You need to accept that cycles happen. GPT should not be put in the same basket as the Centros. At its core is one of the best folios of domestic assets in the country. But they've polluted that with some of the riskiest assets and businesses bought at the top of the market."

Gluskie, pointing to purchases by GPT and Babcock & Brown at the height of the market, says: "Property can still be a good asset class, and one that has the characteristics that investors ultimately seek. But at the moment the industry faces two things. One is the adjustment to underlying valuations of the assets in an environment where credit costs are higher and investors are prepared to pay less for those assets."

Most analysts and investment managers are cautiously confident that low vacancies and an economy still buoyed by low unemployment and demand for mineral resources will tide us through further global economic woes.

"Based on what security prices are doing, the market is saying it expects real estate prices to fall by 30%," PIR's Higgins says.

"We just don't see it happening to that degree. Unless Australia

and the world economy tank and we have a big blow-out in unemployment - then we've all got problems."

source of income, and you're in trouble."

Investors need to be aware of where the property prices being paid were unrealistically high," said Angus Gluskie, managing director of White Funds Management.

There had been strong warnings before this week's implosion.

Investment companies Centro and MFS had been unravelling under the weight of complex corporate structures and an inability to refinance short-term lending in the midst of the credit crunch.

Mirvac and Valad have cut their earnings estimates and distributions in the past month, citing reduced income from development and funds management.

Westpac Office Trust did the same on Wednesday; Lend Lease and Stockland are tipped for downgrades.

The S&P/ASX 200 Real Estate Investment Trust Index is flailing - down nearly 40% over the year, compared with a fall of about 21% in the broader market.

This gap became apparent at the start of the year and has widened sharply since May.

So, what's going on with the property investment vehicle once considered "safe as houses"?

According to Dougald Higgins, from ratings house PIR, the problem began with the push for trusts to stop being simple "rent collectors" and become sexier, more complex beasts."

There has been a certain amount of brainwashing in the market in the past five years," Higgins says. "Pure property trusts were seen as boring. You had to diversify what you were up to . sex it up a bit."

This has involved "stapling" the trust structure to a corporation, which not only gives investors steady income from long-term commercial rent deals, but also allows them exposure to the riskier, more lucrative realm of property development, overseas investment and managed funds.

It was a fantastic combination in a time of low borrowing costs and rising property values, allowing for unprecedented price growth. In the 12 months to September 2007, capital returns grew faster than income in every property sector except for industrial.

With growth and income soaring, investors this week could almost be forgiven for wailing like Whitney Houston: "Didn't we almost have it all?" Many seem to have given up entirely on the sector - but have they overreacted?

Richard Morris says while some REITs have "lost the plot", they could still be a good way for small investors to get exposure to highyielding commercial property - as long as it is domestic."

The funds management model exemplified by Centro and Babcock & Brown is under a lot of pressure at the moment," Morris says. "These type of companies have really overdone it in terms of complexity, overseas exposure and lack of transparency."

Morris and other investment managers say the safest trusts are those that still operate as traditional rent collectors - Commonwealth Property Office Fund, Colonial First State Retail Property Trust and Westfield. Overseas investment has been maligned, and high-quality Australian property is preferred, but there could still be some value in trusts with exposure to countries such as Japan, Germany and Norway.

Some trusts with high gearing, including GPT, are at risk of breaching their loan covenants if the values of their properties fall any further and trigger a review by their bankers. Macquarie DDR and APN/UKA European Retail Trust have yet to sort out their predictions for 2008-09; both are geared over 50%.

Share prices that are well below net asset value have prompted the usual speculation about mergers and acquisitions, but that could be tempered by difficult borrowing conditions and an aversion to risk by nervous boards and managers.

Smaller trusts, and particularly retirement trusts, could be takeover targets. Jonathan Kriska, an analyst at Paterson Securities, said that, in the long term, exposure to retirement is "where you want to be"."

Anyone who's anyone in that space is trying to get a foothold in retirement," Kriska said, citing Lend Lease's recent plays at FKP and Babcock & Brown Communities.

Retirement trusts would still suffer from the decline in residential property prices, with retirees reluctant to sell the family home and move into a retirement village. Most trusts also rely on "deferred management fees", paid when residents leave a home, for income, making revenue more difficult to predict.

But Kriska said consolidation in the market and the weight of demographics would hold it in good stead."

Long term we're undersupplied in the retirement sector. At the moment, there's still a lot of fragmentation. The deferred fee model works better in a broader base company structure where there are other revenue streams there to supplement the shortfall.

Ones that try to wrap it up into a property trust and have to distribute all their earnings are going to struggle."

Whereas previously trusts had included property revaluations and development earnings in calculating their distributions, GPT has revised its policy to exclude development earnings and other resultant capital.

Michael Doble of APN Funds Management says the sector can redeem itself by following GPT's lead in re-evaluating its distributions policy.

Doble said others in a stronger financial position could also follow Westfield's lead and keep dividends steady even as earnings grew. Such short-term pain for investors would be better for the health of the market in the longer term, and investors should be prepared to wait."

I wouldn't be selling at this point," he said. "You need to accept that cycles happen. GPT should not be put in the same basket as the Centros. At its core is one of the best folios of domestic assets in the country. But they've polluted that with some of the riskiest assets and businesses bought at the top of the market."

Gluskie, pointing to purchases by GPT and Babcock & Brown at the height of the market, says: "Property can still be a good asset class, and one that has the characteristics that investors ultimately seek. But at the moment the industry faces two things. One is the adjustment to underlying valuations of the assets in an environment where credit costs are higher and investors are prepared to pay less for those assets."

Most analysts and investment managers are cautiously confident that low vacancies and an economy still buoyed by low unemployment and demand for mineral resources will tide us through further global economic woes."

Based on what security prices are doing, the market is saying it expects real estate prices to fall by 30%," PIR's Higgins says."

We just don't see it happening to that degree. Unless Australia and the world economy tank and we have a big blow-out in unemployment - then we've all got problems."