Property gold: Small caps build momentum

Listed property trusts have run hot … and certain small caps are offering good value.

Summary: Australian real estate investment trusts imploded during the GFC, but a strategic restructure across the sector and a turnaround in market conditions has seen them recover lost ground. And, in the current market, certain small cap stocks are offering good value.
Key take-out: Analysts advise property trust investors to review the quality of tenants, the duration of leases, conditions for rental increases, and how distributions will be funded.
Key beneficiaries: General investors. Category: Growth.

Property stocks appear to be the new gold standard when it comes to defensive assets, as the sector has outperformed just about all other safe haven options during the latest market shake-out.

However, you need to look among the small caps for value given that the S&P/ASX 300 A-REIT (Australian real estate investment trust) Index has rallied 29% over the past 12 months, hitting its highest level since October 2008 on Tuesday.

While cracks in the global recovery story (such as the marked slowdown in China and the bailout of Cyprus) sparked a 4% sell-off in the S&P/ASX 300 index since it surged to a 4½-year high on March 11 this year, the A-REIT benchmark continued to run 2.5% higher.

One could argue that A-REITs have swapped places with gold as a safe harbour from the market turmoil, with the precious metal collapsing around 16% over the past month to under $US1400 an ounce.

Gold worked as a perfect hedge against market anxiety during the global financial crisis, when A-REITs were deeply out of favour due to their opaque corporate structures and very high debt burdens.

Now, not even the world’s reserve currency, the US-dollar, and high-yielding bank stocks can hold a candle to property stocks. Both the greenback and bank equities have dipped since March, as shown in the chart below.

It is easy to see why A-REITs are now considered a safe bet, with the sector having undergone a painful deleveraging cycle and abandoned exotic and unconventional growth strategies since the GFC.

The property sector has gone back to basics with the readoption of the simple landlord model, and this is the key reason why its relatively high dividend payout is generally seen to be sustainable amid the economic turbulence. (Also see Stark choices when shopping for Westfield).

This renewed investor confidence is perhaps best reflected in the sector’s volatility readings in the wake of the latest market correction. The 50-day volatility index for A-REITs is holding 1% below the one-year average, while the S&P/ASX 300 Index’s volatility has spiked 23% above its average.

A-REITs won’t always be seen as a safe asset, but for now it looks like bad news on the international front will only add to the sector’s appeal.

I would even say that more bad news is needed if the sector is to embark on its next leg-up, as fundamentals alone are probably not enough to justify further gains when the sector’s current year forecast yield has fallen to a six-year low of 5.3% compared with 6.5% a year ago (price and yield move in opposite directions).

Investor enthusiasm for property and yield has prompted some companies to come to the market with a float or new unlisted investment products (such as a property syndicate), but investors shouldn’t get caught up in the excitement.

“I would say ‘buyer beware’,” said Stuart Cartledge from property investment firm Phoenix Portfolios.

“There is a perception that the market is just focused on yield and yield only, and anything that delivers yield must be okay. But if you start doing analysis beyond that, you start uncovering [issues].”

He highlighted Shopping Centres Australasia Property Group (SCP), which listed in November last year, as one example of a stock investors should be wary of.

“Investors don’t even understand that Woolworths has sold you a portfolio [of its retail properties] but won’t disclose any information regarding the likely rental increases of their supermarkets,” said Cartledge.

He suspects investors could be waiting for a decade before seeing any rent increase from the supermarket giant, and inflation over the period will eat away at yields and drive up operational costs for the $960 million market cap property group.

SCP has jumped around 14% since listing at $1.40 last year and has a forecast yield of around 7%.

But don’t hope to make 20%-30% returns from property stocks. Those days are gone, with the sector forecast to generate high single-digit returns over the next 12-months, according to the managing director of Atchison Consultants, Ken Atchison.

This means the sector is looking to be at about full value given the near- to medium-term economic and interest rate outlook.

Property Investment Research has reached the same conclusion, with the company rating all stocks under its coverage as a “hold” or "sell". The research firm focuses primarily on large caps.

“There [aren’t] many bargains to be found, at least not amongst the larger REITs,” said its senior analyst, Peter Sahui. “At these levels, we consider it prudent to wait for better opportunities.”

However, a few opportunities do exist at the junior end of the property sector if investors are prepared to do some digging, noted Atchison.

“Small caps do offer better value but are less liquid and [some] are small cap because of poor performance,” he said.

“The rule of thumb for small caps – make sure you do your homework. Do your financial analysis and be wary of gearing.”

Other things investors should be looking out for include the quality of the tenants, the duration of the leases, conditions for rental increases and whether distributions are fully covered by cash flow.

But investors shouldn’t treat the property sector as one homogenous industry. Cartledge is shying away from the residential market, particularly new housing estate development, but he is upbeat on retail properties despite the challenging consumer discretionary environment.

One stock in this space that stands out is Carindale Property Trust (CDP), which owns the Westfield Carindale mall in Brisbane.

“We have been pretty light-on in terms of developments [by shopping centre owners] in the last five years, partly because of the lack of funding,” said Cartledge.

“But there are some good developments going on or starting, and Carrindale is one that has just finished and is fully leased.”

While the stock has raced up close to 30% over the past 12-months, compressing its expected distribution yield to around 5%, it’s still priced at a discount to its net tangible asset value.

CDP is trading at an 11% discount to its net asset value and its 2013-14 forecast enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 17.3 times is 7% below its five-year average.

The $394 million market cap stock gained 2 cents on Tuesday to close at $5.59.

Another interesting small property stock to watch is Australian Education Trust (AEU), even after the childcare properties owner chalked up a stunning 45% total return over the past year.

The stock is still expected to deliver a decent yield of around 7%, which is around 2.5%-3% above the 12-month term deposit rate.

Further, the childcare industry outlook is relatively robust, rents are indexed to the consumer price index (CPI), and the weighted average lease expiry is close to nine years.

The stock added 2.5 cents to $1.44 on Tuesday.


Brendon Lau is the editor of uncapped and may have interests in some of the stocks mentioned in the article.

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