LPT earnings raise questions

When profit realised from asset sales or benefits from derivative instruments represent a substantial proportion of distributions, making up for any shortfall in recurring earnings, increased scrutiny is warranted. Bonus profits from other activities are nice, but they should be just that – a bonus. It is not normally sustainable, nor is it predictable – unlike the core assets of a listed property trust (LPT)

Recurring earnings are thus a critical indicator of whether an entity’s distribution policy is sustainable. It also gives a good indication of business risk: the likely variability of operating income. Operating earnings need to be backed by cash flows in the long term and Property Investment Research (PIR) has identified some LPTs that may experience issues in sustaining distributions.

nFig 1: Distributions and reported distributable earnings for selected LPTs
	Reported underlying distributable earnings [$000]	Transfers as a % of reported earnings	Distribution amount [$000]	% paid out
VPG	31,188	12.00%	34,552	111%
BJT	28,609	6.10%	28,353	99%
IPG	129,466	5.50%	115,941	90%
CPA	82,151	3.40%	82,151	100%
RAT	35,031	54.20%	35,513	101%
IIF	76,400	1.40%	73,600	96%
MCW	95,300	0.50%	97,100	102%
ABP	35,197	0.00%	32,100	91%
MLE	20,061	6.00%	13,715	68%

Figure 1 shows a cross-section of LPTs selected as a representative sample of the variable use of transfers of capital to support distributions. Column 2 shows distributable earnings reported by LPTs, which adjust for items that are not deemed to be part of distributable earnings. For example, most LPTs adjusted their gross AIFRS (International Financial Reporting Standards) consistent profits by taking out net asset revaluations and unrealised derivative gains and losses as well as income from straight lining of rental increases.

This is good news because distributions should not be funded by unrealised capital gains, which are subject to positive and negative movements in accordance with market sentiment and demand/supply and would require the LPT to increase borrowings. Distributions should also reflect income earned during the period rather than expected future income from fixed rental reviews.

Column 3 reflects the proportion of items included in “reported distributable earnings” and are part of the items we generally treat as making up the gap between distributions and earnings (assuming distributable earnings are distributed in the period). The actual distribution amount is reported in column 4 with the proportion of the distribution on earnings stated in column 5.

On average about 3% of transfers to distributable income arise from amortised expenses, with most LPTs indulging in this practice. This is not such a big deal with appropriate scrutiny and within acceptable tolerances. However, there are some whose practices in this regard are worthy of further investigation. One such example is Valad Property Group (VPG), where 12% of the reported distributable earnings figure was partly sourced from transfers to the value of amortisation of intangibles and lease incentives. It also included a transfer equivalent to employee securities ownership plan non-cash benefits, an item the manager may not expect to recur regularly.

This is something we are on the lookout for in future reporting periods. Over the period, a substantial 56% of VPG’s EBITDA was sourced from the corporation compared to 61% on the previous corresponding period. At that level, perhaps this stapled entity would be better off being categorised by the ASX within the Real Estate Management and Development category alongside the likes of Lend Lease.

About 3.4% of Commonwealth Property Fund’s distributable earnings and most of Investa’s 5.5% transfer to distributable earnings (table 1) were made up of amortisation of fitout incentives. Our particular issue with this is that this represents a “reasonable expense”, one whose nature may be more than temporary and thus we remain unconvinced this should be transferred.

On the flip side, IPG’s reported distributable earnings are much greater than its distributions for the period given that it did not distribute profits on the sale of investment properties ($12.5 million net of tax). Overall, 14% of IPG’s EBITDA (excluding asset sale profits) was sourced from the corporation over the period.

The clear standout however is Rubicon America Trust (RAT). The transfer was made up of amortisation of lease incentives, debt establishment, debt novation costs and deferred tax expense. Generally these costs arose as a result of the significant growth through acquisitions during the period. We do not see it as a healthy strategy to transfer amortised debt establishment and particularly debt novation costs purely because they are a non-cash item (for the period in question) given that they represent a cost incurred – despite their potentially irregular nature.

This is where looking at longer-term trends becomes important. PIR looks for recurring operating earnings having a healthy relationship with distributions, subject to some reasonable variance. We also look for recurring operating earnings to have a healthy relationship to cash from operating sources because in the end, distributions should be financed with cash from operations, on average, and thus an analysis of cash flows and earnings through time becomes useful.

Can’t fudge the cash

It is often said that cash is impossible to fake. Well it isn’t, but it’s a lot harder to fake than earnings. Earnings are a relative measure and several adjustments are usually made by LPTs to arrive at earnings figures and consequently obtain distributions.

Figure 2 focuses on how distributions track operating cash flows (Column 2) and how recurring operating earnings as estimated by PIR track operating cash flows (Column 3) with both measures being normalised by revenue. Operating earnings are sourced from the day-to-day operations and exclude asset sale proceeds in the case of passively managed LPTs as well as excluding realised gains on derivative financial instruments.

A positive percentage means that there was excess cash on average (relative to distributions in Column 2 and relative to operating earnings in Column 3). The smaller the magnitude, the closer the relationship.

nFig 2: Average excess cash margin FY04 -FY06
	Excess cash relative to distribution	Excess cash relative to operating earnings
VPG	– 116.80%	– 102.00%
BJT	– 16.60%	19.90%
IPG	– 11.80%	– 8.80%
CPA	– 10.60%	– 6.30%
MCW	– 3.30%	– 6.80%
IIF	– 1.50%	– 7.60%
RAT	– 1.10%	12.70%
ABP	5.50%	6.60%
MLE	12.50%	9.00%

Figure 2 tells a story of the relative operating liquidity. Column 2 gives us an idea of whether there has on average been enough cash to pay for distributions. Column 3 tells us whether earnings have provided liquidity. This is important because the earnings can be there but if they are not matched with cash somewhere down the track then the earnings may not be what they appear to be.

Valad Property Group has a relatively low operating liquidity using these measures. The ratios have in fact been degrading over the period and may be as a result of the substantial growth that Valad has undergone in the recent past. The result reflects substantial acquisition of inventory (properties held for re-sale) in the case of the six month period to December 31, 2006 (first half of 2006-07) and led to negative operating cash flows. Note that this sort of expenditure is classified as “operating expenditure” within Valad’s income statement. It will be worth monitoring Valad’s liquidity, because under normal profitable circumstances the situation should reverse somewhere down the line.

ING Industrial Fund (IIF) and Macquarie Countrywide (MCW) both have on average over the sample period distributed slightly more than their cash flow, nevertheless their operating earnings for the period have on average not tracked cash flows too well. The ratios have nevertheless improved for ING Industrial Fund and appear to only have recently degraded for Macquarie Countrywide, implying possible cash flow timing issues. In the case of ING Industrial, it has historically distributed profits from asset sales and given that these are not included in the operating earnings figures we used for this study it has affected how earnings have tracked cash flows. Its operating earnings result was nevertheless relatively strong in the six months to December 31, with underlying earnings excluding asset sale proceeds marginally higher than distributions for the period.

Despite our previous comments about Rubicon America Trust (RAT), we see that on average over the past three years distributions have tracked operating cash flows relatively well and there has in fact been excess cash relative to earnings. The excess cash relative to operating earnings over the period is mainly as a result of realised derivative gains; for example, from translating US dollar income at beneficial exchange rates. RAT has hedged 100% of its forecast income for the next six to eight years at a weighted average forward exchange rate of 0.6843 US$/A$ and in the event that the rate is persistently high it could ultimately reduce its ability to fund distributions as with many LPTs with foreign property exposure.

Macquarie Leisure (MLE) and Abacus Property Group (ABP) appear to be among the more liquid trusts based on both measures. The ratios have been consistently strong historically for MLE and have been improving in the case of ABP.

Conclusion

After the introduction of AIFRS it has become even more important for analysts to focus on quality of earnings and to adjust earnings for certain non-recurring items as well as for the new accounting standards. In addition, it has also become important for investors to obtain research that is meaningful and can help them decipher the operating performance of their LPTs. Good disclosure is very important and trends in cash flows are a tool to help identify potential health problems that may not be initially apparent through the income statement and balance sheet.

Rubicon America Trust and Valad stood out with significant potentially recurring expenses excluded from distributable earnings during the six months to December 31. To get an idea of whether such treatments are causing harm to LPTs’ operating liquidity/cash flows, it is necessary to monitor the longer-term trends to see whether there is a healthy or close relationship between operating earnings and operating cash flows.

We looked at historical trends and found that a potentially dangerous situation may be building up for Valad. Its aggressive growth of its corporation appears to be causing some operating liquidity issues, which may very well be temporary but still need to be monitored. In the case of RAT, it has not suffered operating liquidity problems in the past; nevertheless it owes much of its earnings and operating liquidity to realised derivative gains which may not be sustainable in the long term.

nFig 3: Average annual compound returns (assuming distributions reinvested) to March 30, 2007
CODE	Trust	1 Year		3 Years		5 Years
		(% pa)	Rank	(% pa)	Rank	(% pa)	Rank
LPT 200 Index		26.61%	13	21.98%	9	18.58%	7
CHC	Charter Hall Group	127.03%	1	n.a.	'”	n.a.	'”
VPG	Valad Property Group	62.58%	2	38.48%	3	n.a.	'”
MXG	Multiplex Group	56.39%	3	5.94%	24	n.a.	'”
GHG	Grand Hotel Group	56.09%	4	31.86%	4	17.13%	10
AEZ	APN/UKA European Retail	54.62%	5	n.a.	'”	n.a.	'”
CNP	Centro Properties	54.40%	6	40.55%	2	30.40%	2
MGQ	Macquarie Goodman	46.70%	7	n.a.	'”	n.a.	'”
ABP	Abacus Property Group	45.88%	8	28.71%	6	n.a.	'”
CDP	Carindale Property	35.72%	9	30.46%	5	22.94%	3
THG	Thakral Holdings Group	34.36%	10	19.94%	11	18.50%	8
MGR	Mirvac Group	29.32%	11	10.70%	23	12.37%	15
SGP	Stockland	28.04%	12	19.79%	12	20.13%	5
DRT	DB Rreef Trust 2	5.49%	14	n.a.	'”	n.a.	'”
GPT	General Property Trust	25.09%	15	23.36%	8	18.79%	6
WDC	Westfield Group	24.08%	16	n.a.	'”	n.a.	'”
MLE	Macquarie Leisure	21.64%	17	49.56%	1	44.74%	1
IPG	Investa Property	20.25%	18	13.74%	19	10.72%	17
CFX	CFS Retail Property	20.08%	19	21.61%	10	20.95%	4
MOF	Macqarie Office	18.54%	20	15.94%	15	11.01%	16
TSO	Tishman Speyer Office	16.16%	21	n.a.	'”	n.a.	'”
IOF	ING Office Fund	15.90%	22	15.00%	16	13.08%	12
MRZ	Mirvac RE Investment Trust	14.80%	23	14.79%	17	12.37%	14
RNY	Reckson NY Trust	13.97%	24	n.a.	'”	n.a.	'”
MPR	Macquarie Prologis	13.89%	25	13.83%	18	n.a.	'”
MIX	Mirvac Industrial Trust	13.05%	26	n.a.	'”	n.a.	'”
RAT	Rubicon America Trust	12.98%	27	n.a.	'”	n.a.	'”
MCW	Macquarie Countrywide	12.04%	28	12.80%	20	12.47%	13
BJT	B&B Japan Trust	11.78%	29	n.a.	'”	n.a.	'”
IIF	ING Industrial Fund	11.69%	30	16.70%	13	14.96%	11
BWP	Bunnings Warehouse	11.45%	31	16.30%	14	17.83%	9
CER	Centro Retail Trust	10.43%	32	n.a.	'”	n.a.	'”
MDT	Macquarie DDR Trust	7.36%	33	11.04%	22	n.a.	'”
REU	Rubicon Europe Trust	6.60%	34	n.a.	'”	n.a.	'”
CPA	Commonwealth Prop	6.12%	35	12.46%	21	10.47%	18
GSA	Galileo Shop. Trust	2.32%	36	24.76%	7	n.a.	'”

Like last month, Charter Hall Group (CHC) was the best performing LPT based on its total return performance over the year to March 31, 2007. Galileo Shopping America Trust (GSA) has moved to last place as the worst-performing LPT with a total return of 2.32% for the past year. In fact, all LPTs with substantial exposure to US dollar denominated assets have taken a hit; Tishman Speyer Office Fund (TSO) has moved from 13th place last month to 21st with its rolling yearly return plummeting from 34% to 16%, Reckson New York Property Trust has moved from 17th to 24th with its total return plunging from 32% to 14%.

Similarly the total yearly rolling total returns for Westfield Group (WDC), Macquarie Office Trust (MOF), Macquarie Prologis Trust (MPR), Macquarie DDR Trust (MDT) and Rubicon America Trust (RAT) have all dropped. One of the reasons behind this is the appreciating Australian dollar with respect to the US dollar with the US$/A$ exchange rate at 0.8089 as at March 31, 2007. All these LPTs hedge a high proportion of the forecast value of their distributions over the medium term and a smaller proportion over the longer term and although a consistently high US$/A$ exchange rate would impact LPTs incomes, the recent movement in LPT security prices may be more related to weaker market sentiment on the US economy which may affect US dollar denominated income.

Nevertheless, the Federal Reserve (the US central bank) expects US growth to continue at a moderate pace over coming quarters. (The Fed forecast 2.5–3% in 2007 and 2.75–3% in 2008. Growth was 3.3% in 2006.) Most market forecasters also predict a soft landing. There are also trust-specific factors at play in the recent weakness.