The recent performance of the Australian listed property sector feels eerily familiar.
From 2000 to 2008, the sector more than doubled – in steady fashion – as debt, overseas acquisitions and moves into funds management fuelled growth. We warned of this combination of rising risks and rising prices in our 2007 Special Report Are your property investments safe as houses?, which contained Sell or Avoid recommendations on most of the sector.
It all unravelled when the global financial crisis struck in 2008. In the space of a year the sector halved and halved agan, as trusts jettisoned recently acquired assets, struggled to refinance debt, and conducted highly dilutive equity issues.
Sector not as risky as pre-GFC
Distribution yields low
Raising Sell prices on three listed property trusts
Since then, the sector has undergone a remarkable recovery, as we explained in Getting a Hold on property trusts last September. Since the depths of the GFC, the sector index has tripled – again in steady fashion – unfortunately, with a few notable exceptions, without us on board.
But what about now? Have Australia’s property trusts learned their lesson, or are they simply sowing the seeds of another collapse? To see if we can find the answer, let's look back to the heady days of 2007 and compare them to the state of the listed property trust sector today.
Passports ready? Pack your bags
One of the main features of the pre-GFC period was that Australian property trusts appeared set on taking over the world. With the financial press and investors cheering, trusts were hoovering up property assets in Europe and the United States.
Arguments were made that trusts should be treated more like shares than boring rent collectors, due to the trading and business income that was being earned. Various trusts such as Centro Properties Group were dubbed ‘the Macquarie Bank of Property Trusts’ due to their aggressive and innovative use of debt to create global property empires.
In Chart 1, the orange bars indicate the proportion of offshore real estate assets held by Australian listed property trusts. In 2007 over 40% of their assets were located outside Australia – in a cornucopia of properties ranging from apartments in Tokyo to industrial properties in Düsseldorf, shopping centres in Poland, office towers in Brussels and suburban low-rise offices in Seattle.
The rationale given for this empire-building was that the listed property trusts could increase earnings per share by buying higher yielding offshore properties using cheap short-term debt sourced from the wholesale market.
It also meant they could show off their shiny new assets in their annual reports and take analysts on exotic site tours. But during the GFC it became clear that too much had been paid for assets that management didn’t really understand and that were hard to administer from the other side of the world.
The belated recognition of these facts saw billions of dollars of offshore real estate sold off between 2009 and 2014, more than halving the foreign real estate exposure on the ASX to around 21% – most of which is comprised of Westfield’s trophy shopping centres in the US and UK and Goodman Group’s Asian distribution centres geared towards the fulfillment of e-commerce. Unlike those bought in 2004–06, the offshore assets owned by the Australian property trusts are narrowly focused and were not purchased to provide a short-term boost to earnings and distributions.
In the short term, like any company a trust can distribute all its profits to shareholders and artificially boost dividends or distributions. Whilst this sugar hit can be sweet for the share price, in the medium term all companies need to retain earnings to maintain the quality of the assets owned by shareholders. If this doesn’t happen, the assets and their earnings power can deteriorate.
Property trusts need to retain profits to pay for maintenance capital expenditure such as repairs to lifts and escalators, new tiles in reception areas, air-conditioning and – in retail and office – incentives provided to new tenants such as office fit-outs. Additionally, if a trust is distributing all its earnings there is no cushion to protect distributions if market conditions change, such as if a significant tenant goes out of business.
In 2007 the property sector was paying out 95% of earnings, on average, with some trusts paying out over 100% (see Chart 1). In that environment, maintenance capital expenditure was financed either by borrowing or issuing more equity; neither of which is desirable for long-term shareholders. When market conditions changed, investors saw significant cuts to distributions. For example, Investa Office cut its distribution from 9.7 cents per unit in 2009 to 3.9 cents per unit.
Currently the payout ratio is a more modest 82%. This allows trusts to pay for maintenance capital expenditure and incentives out of current earnings and makes for more stable distributions. Additionally, the listed trusts are more capable of weathering the inevitable changes in market conditions, without immediate and drastic cuts to distributions.
Ten years ago, the property sector was highly indebted and paying a much higher interest rate on that debt. ‘Innovative’ property trusts such as Centro Properties Group were riding high, delivering earnings and distribution growth by buying assets around the globe.
The strategy employed by many of the ASX listed property trusts was to boost earnings by arbitraging the difference between the higher rental yield on acquired properties and the lower rate at which they could borrow on the short-term wholesale money market.
For example, when Centro acquired a portfolio of 467 small shopping centres across 38 US states for A$3.9 billion in April 2007, management upgraded its forecast for 2008 financial year distribution growth to 17%!
Longer term funding was available, but it was at much higher rates which would not have delivered as much earnings growth.
The flaw in the strategy was the presumption that the benign credit conditions would continue forever, creating a mismatch between funding long-term property assets with short-term debt.
Centro Properties, for example, faced big problems in late 2007 in refinancing US$5.5 billion of debt that was due to be rolled over in a very challenging market. Under these conditions trusts were either forced into administration or, like Goodman, were forced to conduct a series of dilutive equity issues, as shareholders were forced to dip into their pockets to pay the debt that had become due.
Today, the property sector’s overall gearing is quite low at around 30% (debt divided by debt plus equity) and the trusts overall are paying a much lower rate for their debt (see Chart 2). Critically, the quality of the debt is generally higher, with longer terms and coming from a greater range of sources.
For example, SCA Property Group has 30% of its debt due in 2029, 35% in 2021 and the remainder in 2019/2020. The critical difference between 2017 and 2007 has been the larger property trusts being able to access the US debt markets, which has allowed them to place long-term debt at attractive rates swapped back into Australian dollars to avoid currency risks.
After the last results season, I asked the management of several property trusts whether they planned to increase gearing, given that they could access long-term debt at attractive rates. The response was that the investor base of grizzled and cautious fund managers wouldn’t support this due to their memories of the GFC.
Paying the price
Overall, then, the property trust sector doesn’t face the same acute risks it faced in 2007. That trebling in price, though, has brought its own risk, with distribution yields dropping to their lowest in many years. To some degree, that’s warranted by historically low bond yields, but prices will naturally take a hit if those yields start to rise.
Some members with a longer-term perspective and a particular need for income might be prepared to take this risk, as we explained in Getting a Hold on property trusts, and we’re nudging up our Sell prices on some stocks to account for that.
GPT’s Sell price goes from $5.50 to $5.80; Stockland Group’s goes from $5.50 to $6; and BWP Trust goes from $3.00 to $3.30. The increase in our sell price for BWP is based on seeing moves by management to mitigate the impact of Bunnings vacating a number of sites to move to locations formerly occupied by Masters. However, most of the stocks in the sector remain a long way from prices at which we’d be comfortable recommending new purchases.