LPTs: the insiders' view

As listed property trusts become increasing complex, Australian investors need to be acutely aware of exactly what risks their LPT investment is exposing them too. As much as 15% of a typical portfolio may be made of LPTs but make no mistake, Australian LPTs are no longer just defensive stocks for the income-oriented.

Over the past 12 months, the ASX delivered a return of 21.2% while LPTs returned an average 33.9%. These returns have been generated by doing more than just collecting the rent, which makes the views and personalities of the executives crucial to any investment decisions.

Australian property is among the most securitised in the world and as the supply of new investment-grade property has dried up many LPTs have gone offshore, exposing themselves to currency risks. (See Manhattan transfer, from Eureka Report, September 13, 2006.) When money was cheap, they geared themselves up to exploit the gap between interest rates and yields. As the returns from the index improved, they extended their risk profile by acquiring construction and development operations.

Now analysts are getting nervous: Earlier this month, Deutsche Bank's Private Wealth Management division warned: “While listed property has traditionally been seen as a defensive growth asset class, there is alarming evidence demonstrating that it may not always outperform shares in down markets.”

Today we focus on four top fund managers who have assumed control of listed property vehicles in the past couple of years. John Snowden joined Colonial First State in January 2006; Andrew McGrath assumed control of UBS’s Property Securities in February 2006; and Stephen Hayes moved to Perennial about the same time. David Harrison is the joint managing direct of Charter Hall, which began trading as a fully paid security in June 2006.

And, despite the differences in their approach, there are a remarkable number of common threads. Most are unconvinced that present gearing ratios are problematic. They are openly optimistic about the resilience of the US economy and value long-term relationships with trusted teams.

In turn they go their separate ways on what sectors and regions they believe will outperform in the medium term.

John Snowden – Colonial First State

John Snowden joined Colonial First State as head of property securities in January 2006 when there was about $4 billion invested in its securities portfolios. Since then the funds under management has swelled to about $7.8 billion. Snowden has the kind of perspective on Australian LPTs that you can only get by spending more than 20 years in the sector.

“The average level of experience among the senior analysts in the team is about 20 years,” he says. “We’ve built strong relationships with people like Greg Goodman of Macquarie Goodman when his company was a 21¢ stock [today it's $7.25], long before Macquarie bought into the story. Same with people like Nick Lyons of GPT and Andrew Scott of Centro.”

Snowden is “relaxed” about the increased levels of gearing in Australian LPTs, suggesting that the optimal level of gearing is about 45–50%. Rather than the amount of debt, what is more important is the structure of that debt, how much is fixed and how much is floating. In better quality trusts the debt is structured against its tenancy profile, with those earnings providing the coverage for the relevant period.

When asked about how these vehicles will perform in a cycle of tightening interest rates, he says that given the increasingly sophisticated nature of LPTs, rising interest rates are no longer present the same threat they used to because they are no longer quasi fixed-interest securities. “Property securities, generally being a higher-yielding type of security, can outperform even in a cycle of tightening interest rates. I’m fairly relaxed about moderate interest rate increases and their impact on the sector.”

Like many fund managers, he is all too aware of the opportunities presented by the emerging middle class in mainland China. Snowden’s preferred method of exposure to China is through Hong Kong based construction companies. “The businesses we like have development businesses on China’s mainland. Hong Kong has a high level of regulatory infrastructure that’s fairly transparent and that gives us an added degree of confidence.”

Office space in London and New York holds less allure. “Look I’ve got some concerns about the very low cap rates in the UK. In the West End there are examples of property selling at cap rates (yields relative to property value) of around 3% which appears a little high. Parts of the Manhattan office market are also very expensive”.

On the subject of recurring earnings, he says: “It comes back to looking at the management’s ability to grow the earnings of the development and construction businesses in a sustainable way. There are a number of groups that do that well, like Stockland, which has not missed a beat. Westfield is another example. But on the other hand you have teams with a poor track record. Multiplex is an obvious example.”

Looking ahead, Snowden is optimistic, forecasting growth of 12–15% for LPTs globally and about 10% in Australia.

Investors can access a range of securities including First Choice Property Securities and Colonial First State Colliers Global Property Securities through a wrap for $5000 or directly for a minimum of $100,000. These funds returned investors 29.2% and 28.7% respectively for the year to March 31, 2007.

David Harrison – Charter Hall

David Harrison is the joint managing director of the Charter Hall Group (CHC) a stapled security that consists of the Charter Hall Property Trust and Charter Hall Limited, the funds management and property development wing. Along with his co-director David Southam, he's been instrumental driving the business as the stock soared more than 100% over the past 10 months.

Harrison explains the success of Charter Hall. “By recycling capital off our balance sheet we created wholesale unlisted funds and, together with the returns on those funds, we have been able to generate double-digit returns which has produced a very strong expectation in the market place”.

Charter Hall’s properties are concentrated in the office and retail sectors of Australia but the fund has just sewn up $700 million worth of capital for a wholesale industrial fund that sits within Charter Hall Limited. This latest fund is just the most recent in a series of acquisitions that has seen assets under management grow from $800 million to $2.5 billion since the IPO 20 months ago.

Harrison is bullish on retail. “Retail has gone through a tough time, particularly in New South Wales, but we feel the sector is very much a counter-cyclical play now. The yield gap is around 200 basis points now and we don’t believe that’s sustainable. Going forward we believe there is the prospect for capital growth and improved yields as the economy picks up.”

And he’d know. Prior to joining the team at Charter Hall Group, Harrison was the managing director of the commercial real estate agency Savills where he conducted around $6 billion worth of property transactions in capital cities around Australia.

When asked about sectors he expects to underperform, he nominates the Melbourne office market. “The release of cheap land in the Docklands has kept a lid on rental growth in the Melbourne office market. It’s not a sector we have a lot of investment in and we don’t think it will be what you call a high-growth market.”

Asked about the fall in recurring earnings generated by Australian LPTs, Harrison is direct and to the point. “We are still sitting at about probably 80–95% recurrent earnings and 5–20% non-recurrent. We have been in the space for 11 years and the non recurring earnings are generating a portion of our performance.”

Investors can buy Charter Hall on the ASX under the code CHC. Charter Hall also operates a series of unlisted funds including that require a minimum investment of $10,000.

Stephen Hayes – Perennial Investments

Stephen Hayes is a well-known figure in the listed property scene. In January 2006 he was head-hunted by mid-cap financial services group IOOF to run its property trusts under the Perennial Investment Partners banner. A highly regarded talent in the sector, Hayes was able to bring his entire team from Colonial First State with him to the boutique operation.

Hayes is also a well known critic of Australian LPTs. He is particularly critical of LPTs that acquire overseas real estate through a partner. “The structure of buying foreign real estate and pricing in Australian dollars is fundamentally flawed,” he says. “If the currency and interest rates move against them it can lead to very poor Australian dollar returns and it’s got nothing to with whether the real estate delivers good returns locally.”

He says these partnerships also expose investors to “double dipping”, with both the local and foreign fund manager each charging fees. In recent times this has been most obvious when Australian LPTs looked to the US for acquisitions. But Hayes can see parallels with the current rash of funds focused on Japan.

“The stock being picked off in Japan is all highly leveraged and lower quality. Japan is coming off 15 years of stagflation and interest rates are going to go up a lot faster than they are here. It’s a product of large fund managers with too much money and not enough imagination.”

That’s not to say that there are no opportunities in Japan, because Hayes is bullish on the retail sector of Japanese property. “Japan is what we call a net exporter and appears to be moving from an economy based on manufacturing to an economy that is more reliant on services and consumption. There are as few as 93 shopping centres in Japan, and we believe that retail will deliver very good returns over the next five to 10 years.”

His optimism extends to office space in London and Paris, but he makes the point that that the only good way to get exposure to these stocks is by direct buying of property stocks listed on overseas markets like the FTSE and the CAC.

What may concern investors is his outlook for Australian LPTs over the next months. “On a fundamental basis, our forecasts for Australian LPTs on average is zero to 15%. It’s possible that they might just deliver nothing. The earnings of some, especially the externally managed trusts, just aren’t there to justify the premiums.”

Investors can access the Perennial Australian Wholesale Fund and the Perennial Global Property Wholesale Fund directly for a minimum of $25,000. The trusts have returned investors 32.2% and 29.3% respectively to March 31, 2007.

Andrew McGrath – UBS

With 19 years of investment experience, Andrew McGrath assumed responsibility of for the UBS Australian Property Securities Fund early in 2006. He caught the attention of the financial media when he bravely, but unsuccessfully, lobbied the ASX on corporate governance issues related to a conflict of interest in the acrimonious GPT/Lend Lease split of 2004.

Looking after about $1.9 billion worth of capital, McGrath says that the focus on offshore real estate is a natural progression. “Australia is one of the most securitised markets globally and in order for trusts to earn a decent rate of return they need to look to overseas markets. The US market represents about 60% of global capital in LPTs so it’s an obvious target.”

Like our other respondents, McGrath appears relatively relaxed about the recent weakness exhibited by the US economy, and lists a number of his holdings with exposure to the US office and retail markets including Galileo America Shopping Trust, Tishman Speyer, Rubicon America Trust and Reckson New York Property Trust. “We invest in trusts based on their fundamental price to intrinsic value. We do not manage the portfolio solely on a regional basis.”

When asked about recurring earnings, his comments echo those we have heard earlier. “As LPTs have evolved, the challenge for UBS has been to understand the risks presented by the development or funds management side of the business.” The same challenge applies to individual investors. A trust that becomes increasingly reliant on its funds management division to generate its alpha requires investors to have a genuine understanding of the operation and its importance to annual returns.

McGrath is cautiously optimistic about the future. “On a price-to-earnings basis Australian LPTs look fully valued in relation to the broader market. If you look at the longer-term averages investors should be looking at returns in the high single, low double-digit range with a mix of both income and growth.”

Investors can access both the UBS Property Securities Fund and the UBS Global Property Securities Fund directly for a minimum investment of $20,000. The funds have returned 32.9% and 14.2% respectively over the 12 months to March 31, 2007.