Safe haven turns sour

"You maniacs! You blew it up! Ah, damn you! God damn you all to hell!"

Charlton Heston, Planet of the Apes

A shopping centre in Prague. A risky loan over an apartment conversion in Milwaukee. Property managers relying on complicated foreign currency trades to juice up their returns.

Late last year the new mix of Australian property trusts was a heady brew and everyone inside the industry knew it. Since the late 1990s most property trusts had been abandoning their safe, simple "boring" business model of owning property and distributing the rent to investors.

Growth was the game, and there were plenty of far-out schemes investors could sign up to. You name it, they were into it. Babcock & Brown Japan Property Trust was offering investors office blocks in greater Tokyo. In December the APN/UKA European Retail Property Group launched a fund of 16 supermarkets in Greece.

"The practice in stapled securities since 1999-2000 was to chase ever-increasing distributions," says Mirvac's former managing director, Greg Paramor.

Nic Lyons, the chief executive of GPT, says: "The reality has been that the sector has evolved over the last several years and those [traditional] defensive characteristics have been diluted in the pursuit of higher earnings growth."

And how. In late 2006 Rubicon America Trust spent $137 million on risky loans over far-flung US properties to soup up returns by 6 per cent. Rubicon's managing director, Gordon Fell, was also a leading exponent of elaborate foreign currency switcheroos designed to boost returns.

Historically, trusts based purely on property ownership expected to make a return of about 8 per cent. But this was not enough for investors in a global real estate boom and the late years of a bull market, when they were demanding returns well north of 10 per cent.

Most trusts loaded up on debt and sought new revenue to oblige. Through the 2000s even the big names were morphing as they chased the holy grail of growth. Multiplex listed as a trust but exposed investors to the development risk of the Wembley football stadium in England. Goodman Group grew its revenue from being a property manager, as distinct from a property owner, to 31 per cent of total revenues. Stockland relies on land banks and its ability to foster residential property developments. Centro spent billions on regional US shopping centres.

Mirvac's Paramor, before his exit this month, was promising a "back to basics" approach. But Mirvac's most recent half-year results show it was reliant on development for about 40 per cent of its profit result.

Credit Suisse analysts wrote after Mirvac's recent profit downgrade: "Reading notes in the financial statement can be somewhat amusing, with investments in forestry, tourism, debt, toll roads, airports, and really anything that remotely resembles real estate."

And there was more bad news from Mirvac this week as redemptions in three unlisted Mirvac Aqua mortgage funds were suspended for six months.

Behind the scenes, trusts started pushing the envelope on debt. Structures with debt levels of 70 to 80 per cent of their property assets became more commonplace, up from historical levels of 35 to 40 per cent.

And across the industry financial engineering was an accepted fact. A higher and higher level of distributions was paid out of capital - or debt - rather than income from rent.

A JPMorgan analyst, Rob Stanton, estimated in May that for every $1 in forecast property trust distributions this financial year, 84c was supported by cash flows. The rest relies on debt, capital raisings or one-off asset sales.

"Paying in excess of cash flow - essentially you are relying on assets appreciating over time in order to afford that," says Macquarie Group's real estate analyst, Callum Bramah. "In an environment where asset values come under pressure and availability of capital diminishes . you're in a tough position."

In short, what was once a stable, safe-haven investment had become very high risk. One example serves to show the new risks, and the consequences that have rocked the market.

Record Realty, brought to you by the boffins that made Allco a household word, made no secret of the fact its success hinged on a mix of relentlessly rising asset prices and cheap debt. How else could you explain its policy of paying every cent in rent on its interest bill? This was dressed up in annual reports as "returns to investors are enhanced through the use of higher financial leverage".

But it meant any distributions from Record were not covered by cash flows at all. The distributions were, astoundingly, 100 per cent drawn from sources other than "boring" old rent.

But what happens if interest rates go up? And what if asset price rises falter? What if cheap financing is no longer available?

Bottom of the class for Record Realty. Limping, even before the financial crisis, it is now sharing a dark world with its debt-burdened peers: a steady diet of sliding property values, breaches of debt covenants, talks with bankers, suspended distributions and forced asset sales. Its unit price has fallen by 90 per cent and it is the worst-performing property trust in the ASX 300 this year.

And it is bottom of the class, nearly, for property trusts and their managers, because - apart from a few honourable exceptions - they have been caught to varying degrees in exactly the same predicament.

After being a standout performer offering double-digit returns in previous years, the property trust sector has crashed as investors have spurned securities in go-for-growth, debt-fuelled structures.

THE overweening focus on growth was not just at the fringes. Australia's oldest property trust, General Property Trust, which Lend Lease founded then listed in 1971, was seduced in 2005, entering a joint venture with Babcock & Brown that focused on European assets.

Its presentations spoke of "Central Eastern Europe potential" and "immediate access to an earnings 'growth engine' ".

This was in an environment of GPT aggressively selling its split from Lend Lease, and playing up the joint venture business.

Which takes us back to the shopping centre in Prague. The Galerie Butovice was opened in March 2005 and proudly boasts of its main feature, two 60,000-litre tanks with more than 60 species of fish. It was one of the assets in the initial portfolio in the joint venture with Babcock & Brown. And Lend Lease's chief executive, Greg Clarke, was forthright in his view on this transaction as he fought unsuccessfully against the split.

"The proposed investments to be undertaken by the joint venture represent a lower quality of assets than GPT's current high quality portfolio," he said in a speech rejecting the proposed split.

"We seriously question the total returns GPT unit holders will receive when you consider the capital growth prospects of these properties." Clarke also criticised an "overly aggressive" acquisition program for the $4.5 billion joint venture.

And now?

GPT shocked the market on July 7 when it downgraded its 2008 earnings by 27 per cent, leading to a rout on the exchange in the already traumatised sector.

And the joint venture is no longer flavour of the month. GPT's Lyons is saying the fund will not meet its return on equity targets, allowing it to trigger the termination of the joint venture with Babcock & Brown from next year. GPT wants its money back.

But JPMorgan analysts caution that it will not recoup the $1.96 billion it has booked as being inside the joint venture; the investment bankers value GPT's assets at $510 million.

And Galerie Butovice, where the fish are still swimming? It is in breach of its loan covenants. GPT is in talks with its bankers. Its "hold" strategy as a cherished member of the initial portfolio is likely to be a "for sale" strategy.

It is not living up to GPT's earlier promise of "Central Eastern Europe potential". It is no longer "immediate access to an earnings 'growth engine' ".

LYONS is unrepentant about the joint venture, which was not a focus of the earnings downgrade, and he contests JPMorgan's numbers on the probable cash GPT will eventually extract from the joint venture.

His argument is that investors got what they wanted: a growth engine, until the markets changed this year.

"Up until the middle of last year I think the joint venture was valued by the market," Lyons says. His explanation of the sector's appalling predicament has a touch of the "investors made me do it".

"Investors have demanded higher earnings growth," he says. "Listed property trusts have evolved to deliver higher earnings growth and created a range of different models . Higher growth comes with higher volatility and risk. That's the way it happens."

Mirvac's Paramor echoes this sentiment: "There was a belief and indeed a desire for investors in Australia to access other markets around the world through local managers. If there wasn't, no one would have raised a dollar."

But this quest for higher growth and the ensuing malaise, including GPT's exit from its joint venture, is hardly a testament to a "built to last" approach to company development.

Rather, Lyons's position has an air of "built to last until the next cycle, when we will energetically move to unwind what are now untenable positions with as little bloodshed as possible".

"I don't believe any business can truly say you can withstand cycles. You look at every listed entity in Australia. Cycles do impact businesses," Lyons says.

But not every company on the stock exchange was distributing more money to its investors than it earned. Not every company invested 15 per cent of its capital in a joint venture with a debt level approaching 70 per cent.

THINGS are looking grim in Milwaukee since Rubicon, now managed by Allco, funded a Chicago developer, Nick Gouletas, to buy a $US56 million apartment block called Landmark on the Lake in 2005. The plan was to convert apartments into larger "condos".

Rubicon advanced a $US12 million mezzanine loan to Gouletas. Mezzanine financing is used as top-up financing after an original loan, and is riskier because it ranks behind the senior lender.

In late 2006 Rubicon America Trust bought the mezzanine loans from a related party as a "new sustainable growth engine", allocating up to 25 per cent of its assets on the promise it would lift distributions by 6 per cent.

The loans were always at the risky end of the property financing game, with a loan-to-value ratio of more than 80 per cent. In Milwaukee the condo conversion had an even riskier loan-to-value ratio of 86 per cent.

Now the loan is in trouble. In April Rubicon took over from Gouletas as manager and condo prices have been slashed. Tom Daykin, a business reporter at the Milwaukee Journal Sentinel, notes Gouletas bought "around the time the real estate market peaked. You may have heard that US real estate prices, particularly for residential properties, have declined a bit since then."

Rubicon America Trust has taken a $US2.8 million writedown on the Milwaukee loan. But it is easy to get the sense this is only a small example of big problems in the mezzanine loan book, which Rubicon grew throughout 2006 and now stands at $US257 million.

The growth strategy is in tatters. Rubicon America Trust is conducting an impairment analysis of the whole loan book.

Rubicon America Trust is also in breach of its debt covenants to US bondholders and the loan from Credit Suisse supporting the foray into mezzanine loans is teetering on the verge of default.

Rubicon has entered into an ambitious program of forced sales to cut its loan book back and pay back Credit Suisse. The stock has fallen 91 per cent from its highs. Remaining investors are braced for more bad news.

The loans were not a "new sustainable growth engine".

INVESTORS who have not fled the property trust sector are facing a grim time in the coming reporting season. Higher interest rates and falling property values are raising the prospect of large writedowns in the value of property trust assets.

Writedowns would expose investors to the potential of a new round of breached loan covenants, which often depend on an asset-to-debt ratio. And the sector is cutting back its distributions to be matched by underlying cashflow, as their focus moves from growth to survival.

"Reporting season is going to be ugly, more from the point of how it's going to affect investor sentiment," says Dugald Higgins, a director of property research at PIR Independent Research.

"I think a lot of trusts are going to have to wind back distributions. That's not news. The lives they were leading were unsustainable."

Lyons acknowledges the disastrous impact the sector-wide sell-down has had on the reputation of property trusts.

"There's no doubt the sector has lost the confidence of its investment market, particularly for its defensive characteristics," he said.

But he doubts whether investors are ready to go back to the vanilla characteristics of old-style trusts.

"I'm not convinced that it's just going back to what they were 10 years ago," he says.

Paramor is confident investment in property will come back in some form.

"People will hold property in a listed or unlisted form for as long as the world exists, in my opinion," he says.

But he concedes it will take some time to re-establish property as a favoured choice among investors and refers to the last ructions in the property market in the early 1990s.

"The last one took five years from start to finish. You could expect this one to take a similar amount of time," he says.