Australand: Black or blue sky?

Cast your mind back six years or so. Office, retail and industrial property prices were soaring and executive bonuses had more in common with princely ransoms than pay packets. Many believed it would never end. Well it did, in spectacular fashion. Between February 2008 and March 2009 the S&P/ASX 200 Australian Real Estate Trust Index fell a whopping 71%.

Alarmed at the growing debt levels and rush to invest in the United States, we alerted members to the dangers of investing in the likes of Centro (Centro’s American shopping spree on 22 Jun 07 (Avoid - $9.01)), Mirvac (13 Feb 08 (Sell - $4.22)) and Lend Lease (The risk of Lend Lease failing twice on 14 Apr 08 (Avoid - $12.98)) well before the carnage struck.

Since then times have changed. The sector now sports much lower prices (demonstrated by the increase in capitalisation rates – see Shop Talk and Chart 1) and improved balance sheets to the extent that, instead of us recommending you sell property stocks, we’ve been recommending you selectively buy.

Sunland (Pouncing on downtrodden developers on 22 Jan 10 (Long Term Buy - $0.78)), Abacus (30 Nov 10 (Long Term Buy - $2.12) and Australand (Pouncing on downtrodden developers on 22 Jan 10 (Long Term Buy - $0.475)) have all been upgraded in the past 10 months and the case for Australand is now even stronger than it was in January and since our most recent update on 1 Aug 11 (Long Term Buy - $2.48).

The company now offers a substantial 32% discount to net tangible assets (NTA) and an attractive 8.8% distribution yield. If you haven’t yet been attracted to this stock, what follows is the case for a closer look.

Australand feels the pain

In 2007, Australand’s shares hit an all-time high of $13 (adjusted for 1:5 stock consolidation). Within two years they had fallen 93% to 95 cents. As if that wasn’t enough, security holders were hit with several dilutive capital raisings during the global financial crisis (GFC).

Unlike many of the company’s peers that have spent the past decade entranced by risky development projects (Sunland’s Dubai excursion springs to mind), beyond the histrionics of the share price chart Australand has been sensibly diversifying its business.

To complement its residential, industrial and office development divisions, Australand now owns a $2.1bn, 69-building strong property portfolio (see Chart 2). Let’s start by examining that first.

The portfolio comprises new, medium-sized (an average value of $30m) office and commercial buildings, typically developed for a specific client in the Sydney and Melbourne markets.

Most of Australand’s properties are not prestigious CBD addresses, which exposes it to increased vacancy risk; Smaller and less conveniently located properties tend to vacate quicker than prime CBD assets, although this portfolio remained almost 100% tenanted throughout the GFC.

Generating around 70% of total earnings before interest and tax (EBIT), this portfolio provides a reliable income stream for interest payments and distributions and is the major part of Australand’s business.

A developer at heart

The next most significant division is the more risky property development operation. With a focus on residential property, the pipeline is chock full of residential land, homes and apartments with a completion value of $8.1bn. Australand targets the more affordable (less than $600,000) end of the market in NSW and Victoria. The division has performed reasonably well, generating $26m of earnings before interest and tax (EBIT) in the first half of 2011—24% of total group profit.

Australand also develops office and industrial properties, which it either sells or rolls into its own property portfolio. Over the past few years, the company has taken on larger scale developments like 357 Collins St, a $150m cloud tickler in Melbourne’s CBD. Projects such as this are inherently difficult to deliver but they do add high quality assets to the property stable.

Listening to Lynch

Investing in a property group means investing in its assets. As famous investor Peter Lynch advises, ‘when you buy a stock for its book value, you have to have a detailed understanding of what those values really are’.

So let’s consider how Australand’s value would change if its assets were to suffer a significant decline in value—this is a property dependent business after all. In Table 1 we model two bear cases and their effects on Australand’s balance sheet (available as a downloadable Excel spreadsheet).

In Scenario 1 we’ve adjusted property values to demonstrate the impact of a 15% fall in the investment property (increased capitalisation rates) values and 25% write-off of development stock (inventory). This would shrink the discount to NTA from 32% to 16%% but leave Australand within its debt covenants.

Scenario 2 models the effect of a US-style 30%-40% collapse in house prices. In that event, NTA would drop below the current price but, more importantly, debt ratios would soar and banks may become nervous and call in their debts. In effect, a repeat of the calamity of 2008 would be a distinct possibility, including another dilutive capital raising. That would make buying at today’s price a mistake. If you believe house prices are likely to fall significantly or already have large exposure to the housing market through residential property ownership, this is not the stock for you.

Other, more practical, risks exist. Most of Australand’s debt soon expires. $432m needs to be refinanced in 2012 and another $610m in 2013. With $325m available in undrawn credit facilities, $107m in new lending will be needed by December 2012.

Australand’s management knows debt is a concern, having recently confirmed ‘no plans’ to buy back expensive hybrid equity funding (see An opportunity in Australand’s ASSETS On 29 Jul 09 (Buy for yield - $67.00)). We would feel more comfortable if Australand had locked in long-term funding, although majority owner CapitaLand—one of Asia’s largest real estate groups—could provide capital if needed, or may take the company over entirely.

The argument is essentially this: Whilst Australand would suffer in a housing market crash, the current discount to NTA compensates for all but this most dire of outcomes. On an attractive 8.8% distribution yield combined with the potential for future development profits, this is a worthy investment for both income and growth-orientated investors. It remains a LONG TERM BUY for up to 5% of a well-diversified portfolio.

Note: The model Growth and Income portfolios own securities in Australand.