Not WOWed by SCA Property Group

‘When investors are happy to reach for yield’, explains James Montier of GMO, ‘the supply of products available to indulge in this reckless pursuit will seem endless.’ Well, here’s another product to indulge a reckless pursuit.

Woolworths is the latest company to tap investors' insatiable demand for yield, announcing it is spinning off a $1.4bn property portfolio into a new listed vehicle; Shopping Centres Australasia (SCA) Property Group. On a forecast unfranked distribution yield of 6.9%-8.3% backed by long leases, it’s a readymade sale for brokers. We, though, are not taking the bait.

Before listing the many superior options for income-seeking investors, let’s have a look at the offer and explain why we’re turning our noses up at it.

During the global financial crisis when banks weren’t willing to lend for property development, Woolworths started to fund its own projects. The result? Woolworths’s direct property investments exploded from $30m in 2007 to over $4bn today.

The company doesn’t want to be in the long-term property ownership business because each dollar it invests in development is one it can’t return to shareholders. With banks lending again, Woolies is spinning off a portion of its property portfolio.

Existing Woolworths shareholders will receive one SCA security for every five Woolworths shares they own. If, for example, you own 1,000 Woolworths shares you'll receive 200 SCA (1,000/5 = 200) securities, worth between $252-$300 (200 x $1.26-$1.50). Others are being offered securities for between $1.26-$1.50 (see Table 1).

National brand, regional assets

SCA will own 69 shopping centres (56 currently complete, 13 under-development) in regional and suburban Australia and New Zealand, all built or renovated over the past few years. These centres will be anchored by household names such as Woolworths, Big W and Dan Murphy’s.

The tenant mix is a key selling feature, with Woolworths group businesses signed up to pay 61% of total rent received. The remainder will come from speciality tenants with a focus on services and fresh food. That’s no bad thing. These businesses are less susceptible to the economic cycle and face a lesser threat from online retailing than discretionary retailers like fashion stores.

With 39% of SCA’s income coming from shorter, riskier speciality tenant leases, it’s a very different proposition than, say, BWP Trust, which owns Bunnings Warehouses, leased almost exclusively by Bunnings’ parent company Wesfarmers on long, secure leases.

Nor is SCA a Westfield Group-like business. It won’t be able to charge speciality tenants premium rents because traffic will be lower and the locations aren’t as attractive.

Westfield charges specialty retailers about six times more per square metre on average than anchor tenants like supermarkets and department stores, meaning Westfield is heavily reliant on those rents to produce profits and growth.

SCA's specialty tenants won’t pay anything like six times the rent per square metre than supermarkets, which means it is far more dependant on the rents charged to Woolies to produce profits and pay distributions. That has huge implications for its growth prospects.

Table 2 offers comparisons between SCA, Stockland, Westfield and BWP Trust.

Woolworths is well aware of the shortcomings in this offer, which explains why it’s providing a rent guarantee for the first two years of operations. If SCA is unable to fill the 20% of speciality tenancies that remain vacant, income and therefore distributions may fall thereafter.

Stacked in Woolies' favour

Let’s get back to SCA’s dependence on supermarket rents. Rents for speciality tenants rise with inflation but it’s a very different story with supermarket leases. The prospectus highlights the benefit of long leases to Woolworths, which are mostly for 23 years, with four 10-year renewal options. The supermarket rents comprise two parts: base rent, which will increase by a minimum of 5% every five years for the first 15 years, plus a bonus portion based on sales.

The prospectus doesn’t disclose when these bonus rents might cut in, despite the fact that the thresholds matter very much. There’s a huge difference between rent increasing based upon a 1% rise in sales compared with a 10% increase.

What we can conclude from the prospectus is that if the deal actually favoured SCA it would be highlighted in the first few pages of the document. Instead, a reference on page 124 of the prospectus admits that ‘none of the tenants have achieved the required sales threshold in order to be required to pay turnover rents’. Right.

With central bank printing presses working overtime, the risk of the current yield being eaten away by inflation is very real (see Quantitative easing made easy). That Woolies' rent might only rise by 5% every five years means that SCA growth prospects are particularly poor too.

Let’s say it again. Inflation could seriously erode real returns, especially over 63 years. BWP Trust on the other hand has 75% of its rent linked to CPI—a much more typical arrangement.

SCA’s future growth plans are also vague. It may buy more properties, perhaps from Woolworths, although it’s under no obligation to, or it may develop new assets. Either way, a debt to assets ratio of 34% means any expansion will most likely require investors to tip in more cash (see Table 2).

These shortcomings could be overlooked if the price was attractive but on a forecast yield of between 6.9% and 8.3%, based on inflated occupancy figures, it isn’t. The fact that inflation may see even these returns eroded further only compounds an already weak case.

Better options abound

If you aren’t a Woolies shareholder, this is one to avoid. If you are there’s most likely no need to do anything. Post-float SCA is likely to implement a 'small parcel redemption facility' for those who receive around $500 worth of SCA securities (or 330-400 securities). If implemented, this will result in your stake being automatically sold, unless you advise SCA in writing that you’d like to keep your holding. More details will be forthcoming post-float.

Woolworths shareholders who can’t use this facility should sell on market and consider reinvesting the proceeds in Woolworths ordinary shares. It offers a 6.2% gross dividend yield and far brighter prospects. The SCA deal is tipped firmly in Woolies' favour so why not get on the right end of it?

The potential for vacancies within SCA’s portfolio means potential investors should demand a higher starting yield if it is to compare favourably with other A-REITS. But they’re not getting it.

In fact, not only are the yields from other trusts comparable, being more exposed to speciality rents with annual rent increases potentially equal to inflation plus 1% or 2%, they're likely to grow faster, too. Westfield, due to its huge development pipeline, makes an even stronger growth case.

Members seeking income from the property sector should focus on our preferred picks. ALE Property Group is on our Buy list, sports a 7.1% distribution yield and enjoys far more favourable lease conditions.

GPT Group, CFS Retail, Stockland and Westfield Group, all a tad too expensive to officially upgrade, would suit investors focused on owning quality, lower risk assets. They currently offer respective yields of 5.3%, 6.7%, 6.7% and 4.8%. Finally, Abacus Property Group, on a yield of 8.1%, might suit those happier to take on more risk.

We’ll update you if the situation after the float changes but until then, AVOID SCA Property Group.

Note: The Income and Growth portfolios own shares in Woolworths and we intend to sell our SCA Property Group allotment.