Top 5 financial ratios: Listed property sector

In the first of our series revealing the top five ratios for each industry, we show you how to assess an investment in the listed property sector.

'The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.'
In penning those words, English writer G K Chesterton inadvertently laid out the case for avoiding investments based solely on the numbers in a few annual reports or a prospectus. Such numbers merely reflect historical performance which, as the footnotes explain, may not be a reliable guide to the future.
However, a basic understanding of accounting is an essential weapon in an investor's armoury. Warren Buffett has described accounting as the language of business, and financial ratios can help us better understand a business. But the value lies in knowing which ones are relevant to an industry.
In this series, our analysts will select and explain the five most useful ratios for each of a variety of industries.
The property sector is first on our hit list and there are, essentially, three major questions we ask of any potential investment. First, is the distribution yield attractive and sustainable? Second, how much risk is involved (particularly due to debt financing)? And, third, does the market price provide today's buyer with a margin of safety?
To illustrate how we go about answering those questions in practice, let's run the rule over CFS Retail Property Trust.

Distribution yield

The yield represents the annual income return on your investment (before taking capital gains or losses into account). To calculate it, we tot up the distributions paid in any given 12 month period and divide that figure by the current security price.
Table 1 lays out CFS Retail's historical yield using the 2009 distributions. We've also calculated the more important forecast yield based on management's aim of paying a 12.5 cent distribution in 2010.

Table 1
 Distribution yield
Security price ($)1.855
2009 distribution (cents) 12.5
Historical yield (%) 6.7
2010F distribution (cents) 12.5
Forecast yield (%) 6.7

That the result is the same is not a mistake. CFS Retail is the only listed trust that expects to maintain its distribution in 2010, which partly explains its rather pedestrian yield.
During the downturn, CFS Retail offered a safe harbour for investors battered by highly geared property groups that were drowning in debt and slashing distributions. In stark contrast to the boom years, investors are currently prepared to sacrifice potentially high returns for relative safety.
It's also important to understand whether the distributions are being paid out of steady cash from property ownership, or more unpredictable earnings from things like property development. CFS Retail is busy expanding and polishing several of its gems, but the distribution is supported by steady rents and Australians' penchant for shopping.
So, with that in mind, let's press on to our second ratio, which gets to the key topic of risk.

 

Debt ratio

Net debt-to-equity provides the most conservative measure of leverage, or 'gearing' ('net debt' is defined as total debt less cash). However, it's standard practice in the property industry to use debt-to-tangible assets, which measures the portion of assets funded by debt. It's the same way you might describe a $500,000 property financed with a $400,000 mortgage as being 80% geared (the corresponding net debt-to-equity ratio would be 400%). We've calculated these figures for CFS Retail in Table 2.

Table 2
 Debt ratio
Debt ($m)1,957.3
Cash ($m) 4.3
Net debt ($m) 1,953.1
Equity ($m) 4,977.2
Net debt-to-equity (%) 39
Total tangible assets ($m) 7,321.8
Debt-to-tangible assets (%) 27

The appropriate ratio depends on a number of factors such as a property trust's diversification (by factors such as geography, tenant and sector) and the quality of its portfolio. The higher the quality and the more diversified it is, the higher the debt level it can reasonably be expected to shoulder.
We're a conservative bunch at The Intelligent Investor and, even for a high quality, well diversified portfolio we'd start to get a little nervous above 50% debt to assets (that is, 100% net debt-to-equity). For lower quality or less diversified portfolios, we'd want to see a ratio below, perhaps, 30% (around 45% net debt-to-equity)
We wouldn't rule out trusts with heavier debt burdens, but we'd demand a higher potential return for taking on the additional risk; we're very comfortable with CFS Retail's gearing.
In assessing the portfolio's quality we'd also want to consider its underlying characteristics, which brings us to our next ratio, the occupancy rate.

 

Occupancy rate

CFS Retail's occupancy rate has coasted at over 99.5% for many years, due to prime real estate that includes Chatswood Chase in Sydney and Chadstone Shopping Centre in Melbourne, for example. Despite the downturn, CFS Retail has barely suffered a storefront without a paying tenant.
The flipside, however, is that a recovery in occupancy rates won't boost distributions like it will for Abacus Property, for example, which currently boasts a modest occupancy rate of 90%. Low occupancy rates also mean lower property values, which we measure using the capitalisation rate, or 'cap rate'.

Cap rate

Cap rate is industry jargon for the yield on an office tower, big shed or shopping centre. Cap rates move inversely to property values. For example, property trusts that own several trophy assets, like Westfield and CFS Retail, will boast lower cap rates due to superior locations that enable them to extract higher rents from tenants. All you need to know about cap rates provides a more detailed explanation.
As we've recently seen from the red ink spilled across the sector, property values wax and wane with the business and interest rate cycle. You can see the recent cyclical swing in Chart 1, which also illustrates the high quality of CFS Retail's portfolio.

NTA

The final piece in the puzzle is to establish whether there's a large margin of safety, which we do by comparing the trust's net tangible asset (NTA) value per security with the current price. Table 3 shows the calculation, to which we'll now turn.

Table 3
 NTA
Total assets ($m)7,321.8
Intangible assets ($m) 0.0
Tangible assets ($m) 7,321.8
Total liabilities ($m) (2,344.6)
Net tangible assets (%) 4,977.2
Securities on issue (m) 2,464.9
NTA per security (%) 2.02
Security price ($) 1.855
Discount to NTA (%) 8.1

As you can see, the current discount is a moderate 8.1%, which won't provide a lot of protection should property values take a tumble. However, the comparatively small discount reflects CFS Retail's high quality assets and the fact that its current developments, including the flagship Myer building in Melbourne's Bourke Street Mall, should add value when the doors are finally opened.

 

Wrapping it up

The listed property sector is among the easiest to analyse, but focusing on just a few ratios can blind you to some larger risks, which is what Chesterton was alerting us to; things are never as simple as they seem. For example, insidious joint ventures, which we explained in Macquarie Office's soft underbelly, can potentially threaten the viability of a trust.
A trust's strategy is also important. CFS Retail, Bunnings Warehouse Property Trust and Commonwealth Property Office Fund have performed relatively well recently because they stuck to their knitting and avoided debt-fuelled overseas acquisitions.
When GPT Group laid the foundations of the listed property trust sector in 1971, listing as General Property Trust, its worthy aim was to provide a steady stream of distributions from collecting rents. Much of the sector lost its way in recent years, though thankfully we were able to avoid the worst of the fallout (see Are your property investments safe as houses? from 2007).
There was little magic in our analysis at the time. It rested largely on the kind of quantitative analysis we've covered in this article combined with some judgments about the managers involved, their animal spirits and their incentives (to enlarge their asset bases in order to rake in more management fees). The analytical ratios covered here served us well through the last property cycle and we expect they'll do the same through the next one.

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