With interest rates so low in recent years, listed property trusts have been on a tear. The ASX 200 A-REIT Accumulation index has more than doubled over the past five years as investors have been attracted to listed property trusts’ relatively high yields. Not bad for what are primarily a bunch of boring rent collectors.
Pub owner ALE Property has performed even better, rising 164% including dividends since we first upgraded it five years ago. Its 7.7% yield at the time has no doubt contributed to this rise but just as important are the terms on which its pubs are leased to Australian Leisure and Hospitality (ALH), 75% owned by Woolworths.
Updated property valuations released
Remains well placed for rent review
Increasing Sell price
A good brew
Let’s recap the investment case.
ALE owns 86 pubs leased to ALH on leases that expire in 2028, with ALH having four options to extend them for additional periods of 10 years each.
The leases are ‘triple-net’ – see Shoptalk – which means that ALH rather than ALE incurs virtually all ongoing costs other than land tax in Queensland.
|Triple net leases mean the tenant, ALH, (as opposed to the landlord, ALE) pays just about every incidental expense related to the property—from insurance through to maintenance capital expenditure (maintaining the building and fixed assets to a high standard).|
With any capital improvements to the pubs funded by ALH but owned by ALE on expiry of the leases, this reduces the incentive for ALH to improve the pubs. Nevertheless, ALH has spent considerable sums over the years renovating various pubs such as the Crows Nest Hotel in northern Sydney while adding various Dan Murphys on some of the large amount of surplus land in ALE’s portfolio.
While ALE’s rental income increases annually by inflation – as measured by the various state CPIs – there is a rent review scheduled for 2018, capped to a 10% increase or decrease in rent, as well as a full market rent review in 2028.
When ALE and ALH were spun off from Fosters in 2003, the terms of the lease agreements meant that the rents paid by ALH were below market levels (that is, the properties were 'under-rented'). Since then, capital expenditure, changes to pokie laws in Victoria – where around half of its pubs are located (by value) – and the trend away from lower-margin mainstream beers to higher-margin craft beers have all contributed to ALH’s earnings before interest, tax, depreciation, amortisation and rent (EBITDAR) rising faster than inflation.
When we upgraded ALE five years ago, we believed that this boded well for ALE come the limited rent review in 2018 and, in particular, the full market rent review in 2028.
We still do.
Extent of under-renting
However, because we don’t have access to the operating performance of the 86 pubs, the best we can do is make an educated guess as to the degree of under-renting. And because we are value investors requiring a margin of safety, we took our traditionally conservative line in doing so.
Happily, the latest property valuations released by ALE suggests we have, if anything, been too conservative.
Similar to the assets of other listed property trusts – whether they’re pubs, office towers, industrial sheds or shopping centres – ALE has traditionally valued its properties using the capitalisation rate method.
Under this method, a property’s value is estimated by ‘capitalising’ its net operating income using a capitalisation rate. To use an example, if a pub’s net operating income is $1m and the applicable capitalisation rate is 5%, its estimated valued is $20m (that is, the value for which a 5% return gives you that $1m).
As discussed in All you need to know about cap rates, in theory the applicable capitalisation rate should consider the long-term bond rate and a risk premium, reduced for anticipated rental growth.
In practice, however, valuers tend to use recent market transactions to help determine the applicable capitalisation rate of a similar property, which introduces a degree of circularity into the calculations and can cause its own problems.
Discounted cash flow method
Unfortunately, it is difficult to value a pub using the capitalisation rate method if its rental income is assumed to increase by 10% in 2018, then rises by inflation for the next decade, then perhaps rises by a lot more than 10% in 2028 as a result of the full market rent review.
This is why in recent times, more emphasis has been placed on using a discounted cash flow valuation to value ALE’s pubs. Even so, ALE’s average capitalisation rate of 5.13%, down from 5.53% in 2016, still places a much greater emphasis on the capitalisation rate method.
The effect of this can be seen in the 33 pubs which were subject to discounted cash flow valuations in the latest valuation – their average capitalisation rate under this method is 4.48%, substantially less from the 5.13% average above. That the valuers used what appear to be conservative assumptions, particularly in relation to ALH’s EBITDAR growth and the assumed capitalisation rate in 2028, is even more comforting.
Increasing price guide
On the basis of all that, we’re increasing our Sell price on ALE from $5 to $6. This gives us more room to keep holding what is almost a long-term bond with inflation protection and a couple of other attractions: namely, material under-renting, with an upcoming limited rent review and a full market rent review in 2028.
A 10.25 cent final dividend means the total dividend for 2017 should be 20.4 cents, representing an unfranked yield of 4.4% at current prices. And with gearing below management's target of 50–55%, there may be a special distribution following the 2018 limited rent review.
If gains of the stock have taken your holding beyond our maximum recommended weighting of 6%, however, we recommend you take some profit to stay below that level. As attractive as ALE is, like any company it does have risks, particularly a potential rise in long-term interest rates. That could reduce the value of its pubs while also increasing the margin it pays on its debt when it is refinanced. Any changes to gaming laws could also affect the profitability of its pubs. With that said, we continue to recommend you HOLD.