Can smaller property trusts boost your income?

With the search for income pushing down the yields of larger property trusts, we take a look at the income on offer in smaller REITs.

As John Addis explained last week, the most important things for value investors to do in response to falling yields are (a) get used to it, and (b) keep looking for value.

While traditional income stocks are looking increasingly expensive, there are still a variety of stocks offering an attractive combination of value and yield – and our Growth and Equity Income Portfolios hold a bunch of them.

Key Points

  • Yields are currently higher for smaller property trusts.

  • Smaller property trusts offer exposure to niche sectors large players don't.

  • No official coverage.

The trick, as ever, is to be prepared to search where others aren’t looking. While the market certainly has its eye on the larger property trusts – with the likes of Scentre and Goodman yielding just 4.5% and 3.2% respectively – we decided to have a rummage around the nether regions of the sector to find something chunkier.

And we did, although not enough, unfortunately, to make up for the greater risks. Those with particular interest in certain niches, however, might judge the balance between risk and reward differently, so here are the four most interesting stocks we turned up.

Asia Pacific Data Centre Group

According to data centre developer and operator NEXTDC, the cost of fitting out a data centre is often twice the value of the land and buildings in which the technology resides.

Table 1: Asia Pacific Data Centre Group
Ticker AJD
Share price $1.41
Market cap. $161m
No. of properties 3
Gearing* 11%
NTA per share** $1.25
Forward dist. yield 6.70%
*Net debt/(total tang. assets — cash)
** As at 31/12/2105

This was a major drain on resources as it sought to expand, so in 2012 (with alternative sources of funding scarce) it established Asia Pacific Data Centres to buy the properties and lease them back to NEXTDC.

This provided NEXTDC with extra funds to kit out its new properties, but meant that it kept some control of the properties.

The leases are on ‘triple net’ terms. This means NEXTDC has to pay all the costs of running the properties including structural maintenance. Asia Pacific only needs to cover the costs of running the trust.

However, this limited exposure to the properties’ running costs means that Asia Pacific is mostly limited to inflation-linked rent increases. Market reviews do happen every five years but any resulting rent increases are capped at 10%.

The trust offers a tantalising yield of almost 7%, but it needs to be balanced against the risks.

The biggest risk, of course, is the lack of diversification. Asia Pacific only has three properties (located in Sydney, Melbourne and Perth). They’re all data centres and they’re all leased to NEXTDC. It’s only since last December Asia Pacific has even been allowed to own data centres not operated by NEXTDC, but so far no deals have been forthcoming.

The properties show a broader geographical spread, being located in Sydney, Melbourne and Perth. But they’re outside the central business districts – in Macquarie Park, Port Melbourne, and Malaga – which increases the risks a little.

Finally, growth will be hard to come by, with suitable sites for data centres in short supply due to the necessary size and protection from natural disasters like earthquakes and floods. If suitable sites do become available, an equity raising is likely to be needed to purchase them. Properties typically cost $30m–70m, depending on size, and Asia Pacific only has the capacity to borrow a further $10m or so before it risks breaching existing debt covenants.

With inflation stuck at 2% (if the RBA is lucky), the total return adds up to just shy of 9% a year, plus a little – maybe – from the five-yearly market-based rent reviews. That’s not quite enough to cover the extra risks compared to larger and more reliable trusts.

Arena REIT

If data centres and technology are not your thing, perhaps childcare and medical centres are.

Table 2: Arena REIT
Ticker ARF
Security Price $2.00
Market Cap. $459 million
No. of properties 201
Gearing* 26%
NTA per share** $1.46
Forward dist. Yield 5.60%
*Net debt/(total tang. assets — cash)
** As at 31/12/2105

One advantage childcare and medical centres offer is that they’re largely unaffected by the structural change technology is causing in other real estate sectors like retail and office.

Arena owns 179 childcare centres and seven medical centres, predominately on the east coast of Australia.

Childcare is an extremely competitive industry. However, Arena attempts to get around this by targeting regions it considers undersupplied (where there are four or more children to every one childcare place), thus maximising occupancy.

Arena’s leases are also on triple net terms, but they allow for rent increases slightly greater than inflation (at least while it remains low). The rent for childcare centres increases by the higher of inflation and 2.5%, while the rent on medical centres rises at the greater of inflation and 3%. Market rent reviews are typically held after 10 years, with a cap on total rental growth of around 7%.

Arena has a significant development business with a pipeline of around $30 million. Development is its main growth engine with a 9% expected return, compared to the 6% it expects to make from acquiring existing properties.

The development activity and above-inflation rental increases have enabled Arena to increase its distributions by 11% a year since it listed in 2013. If it could keep this up, it would make almost any yield look attractive – let alone the 5.6% it currently offers.

However, we have our doubts that such growth can continue. Arena is not the only company developing childcare centres (see Folkestone below) and it will become increasingly hard to find undersupplied areas. As time goes on, the company’s distribution growth will be increasingly limited to rent increases.

Folkestone Education Trust

Folkestone Education Trust is similar to Arena. Indeed there have been rumours that it may be interested in taking over its smaller rival. Folkestone owns 396 childcare properties and has a pipeline of almost $96 million worth of future development.

Table 3: Folkestone Education Trust
Ticker FET
Security Price $2.65
Market Cap. $652 million
No. of properties 396
Gearing* 27%
NTA per share** $2.00
Forward dist. Yield 4.90%
*Net debt/(total tang. assets — cash)
** As at 31/12/2105

In Australia, its geographic spread is such that almost half of the population is located within 5km of one of its centres.

Folkestone also provides some exposure to New Zealand, where almost 10% of its properties by value are located.

In the six months to December 2015, Folkestone increased distributable income by more than 29% compared to the same period in 2014. Whilst this sounds impressive, it was mainly due to the merger with the Folkestone Social Infrastructure Trust, which added around 50 new centres and an additional $3 million in distributable profit — around two-thirds of the increase. However, due to total shares on issue increasing by around $30 million, distributions only increased to 13 cents per share from 12 cents per share.

While it has more properties than Arena, its sole focus on childcare means it has less tenant diversification, with industry leader Goodstart Early Learning providing more than 60% of Folkestone’s rent compared to 45% of Arena’s.

Like Arena, Folkestone has been augmenting its growth through development, with distributions growing by an average of 10% since 2011. It is only forecasting 5% for 2016 and we think this is likely to be a better indication of the future, which makes the 4.9% distribution yield look a little low.

National Storage REIT

National Storage owns and operates 50 self-storage centres throughout Australia, whilst managing another 29 on behalf of third parties. The nature of its business is reflected in a much lower occupancy than traditional property trusts – at 71% – and a much higher churn rate, with tenants typically on minimum lease terms of only a month and more than 40% leasing their storage facility for less than a year.

Table 4: National Storage REIT
Ticker NSR
Security Price $1.898
Market Capitalisation $614 million
Distributions paid Half-Yearly
Properties owned 50
Gearing* 24%
NTA per share** $1.12
Forward dist. Yield 4.80%
*Net debt/(total tang. assets — cash)
** As at 31/12/2105

In many ways National Storage is more like an operating company than a property trust. Along with rent, it also earns revenue by providing moving services, by selling boxes and insurance and offering car and truck hire. In the six months to 31 December 2015, these services generated over $3 million in revenue – 8% of the total and a 13% increase on the same period in 2014.

National Storage has been expanding aggressively since its float in 2013, increasing its number of owned locations by 78% and its managed locations by 21%. It continues to look for more. Acquisitions make sense as it’s hard to find large enough sites in good enough locations that can be developed at affordable prices. With only 25% of the market controlled by the top three businesses, further consolidation seems likely.

The company enjoys economies of scale through its security and administrative trechnology and centralised call centre and this means that new centres will increase group margins as well as reducing the volatility in occupancy and rent. Greater scale also means it can provide commercial customers with an Australia-wide solution to their storage requirements that can be controlled from a single desk.

National Storage is the riskiest of the four trusts covered in this article. If it can increase its occupancy levels and/or continue to find affordable sites to acquire, it might find enough growth to make its 4.8% yield look attractive. However, with occupancy stuck at 71% since its float and the market for sites becoming increasingly competitive, we would want to see more obvious value before investing.

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