Whether due to central bank policies, slow economic growth or both, historically low interest rates are distorting asset prices everywhere. Listed property trusts have been major beneficiaries from the resulting higher commercial property prices, while falling debt costs have also meant higher distributions for shareholders.
Interest rates could indeed stay at current levels – or go even lower – in coming decades but if you want to profit from sky high commercial property prices, this is as good a time as any. So we’re not surprised that Viva Energy REIT (VVR, "Viva REIT") is taking the opportunity to become Australia’s first listed owner of petrol stations.
After a sale and leaseback transaction with Viva Energy Group (“Viva Group”), Viva REIT will own the freehold title to 425 service stations that form part of the alliance between Shell and Coles, owned by Wesfarmers. Viva Group will continue to supply Shell-branded products to the service stations while Coles Express will continue to operate them and the attached convenience stores.
Petrol stations good assets
Long leases, strong covenant
Sure beats working
The 425 services stations owned by Viva REIT are spread throughout Australia and were acquired from Shell in August 2014 by a consortium led by global energy and commodities company Vitol. The consortium paid $2.9bn for most of Shell Australia’s fuel refining and marketing business, including the 425 freehold service stations, another 450 or so on lease or operated by third parties, a refinery in Geelong and a bulk fuels, chemicals and lubricants business.
Less than two years later, the 425 service stations alone are valued at $2.1bn, which represents a nice gain on their $720m book value and $1.1bn tax cost base. Whatever figure you use, it’s not bad for two years’ work.
Even more so when you consider the $2.1bn valuation is the sum of the individual properties’ valuations rather than the estimated value if the portfolio was sold as a whole. Perhaps this is why Viva REIT shares are being sold at a 10% premium to their $2.00 net tangible assets per share, for a forward yield of 5.9% (unfranked).
The offer isn’t underwritten and Viva Group hasn't committed to holding any of its remaining 40% shareholding in escrow. There are good reasons for Viva Group's confidence: Viva REIT’s leases are triple-net and have an average length of 15 years with rent increasing at 3% a year, and Viva Group and Coles are large, financially strong companies. These attributes are highly sought after in a world of rock-bottom bond rates, so we wonder why Viva Group's brokers are being paid 1.5% of the proceeds when they’ll likely have to turn people away.
Petrol stations good assets
Around three-quarters of Viva REITs assets are in metropolitan areas. This makes them easily accessible to motorists, which is a big plus given that fuel retailing is such a competitive, high-volume, low-margin business. Metropolitan sites also offer the potential to be converted to other uses, such as apartments, although Viva REIT would be on the hook for any environmental remediation costs. This also provides some protection if electric cars increase in popularity and reduce demand for fuel.
|NTA per share ($)||2.00|
|No. of shares on issue (m)||690.2|
|Premium to NTA (%)||10|
|Dividend yield (2017F) (%)||5.9|
|Retail offer opens||19 Jul 16|
|Retail offer closes||28 Jul 16|
|ASX trading commences||3 Aug 16|
Like most commercial property, competition for the best located and most profitable service stations has been strong in recent years, with sub-5% capitalisation rates not uncommon (the lower the capitalisation rate, the higher the price). Investors purchasing shares in Viva REIT will be paying a 5.5% capitalisation rate on average.
Competition for sites hasn’t just led to higher prices: it's also pushed up service station rents, which are based on a percentage of gross fuel margin and also convenience store sales. Under the sale and leaseback, Viva Group will pay current market rents to Viva REIT, increasing by 3% a year until the leases expire in 15 years on average.
However, over this period Viva Group will continue to benefit from its sub-leases to Coles. Coles Express like-for-like sales rose by 5.2% per year from 2007-2015 and are likely to keep rising by more than 3%. Moreover, Viva Group will continue to earn income from the Shell card programme and also continue to supply Coles with fuel so it will also benefit if the trend towards higher margin premium unleaded and diesel fuels continues and offsets declining fuel volumes.
Viva Group will also manage Viva REIT and be paid around $7m or 0.32% of gross assets in 2017 for the privilege even though there really isn't much to manage.
Is it a Buy?
Viva REIT shareholders will have to wait until the leases are renewed to benefit from any improvements in the service stations’ fundamentals. Further, whilst the leases are triple-net, there’s little scope for the tenant to undertake major capital works to increase returns from its properties.
However, if you have dreams of being a petrol station landlord, properties belonging to the Coles-Shell or Woolworths-Caltex alliances are the most attractive. The shopper docket fuel discounts offered by Coles and Woolworths give them a strong advantages over their competitors. Moreover, they view the fuel retailing business as a means to getting customers to shop in the attached convenience stores – and also any co-located fast food stores, car washes, ATMs, etc – where margins are twice those of their supermarkets.
The financial strength of Viva Group and Coles also makes Viva REIT’s income very reliable. The Shell-Coles alliance and Viva Group’s licensing agreement with Shell expire in 2024 but the importance of these arrangements to all parties means they’re likely to be renewed. If the trend towards premium fuels continues and Coles Express increases like for like sales at greater than 3% over the next decade or so, then you’re likely to benefit from higher rents when and if Viva Group renews its leases.
Until then, however, with 100% occupancy and rents increasing by just 3% per year for ten years before the first market rent reviews, growth will be limited. As such, Viva REIT’s strategy is to add to its network – both within and outside the Coles-Shell alliance – here and in New Zealand. Committed to paying out 100% of cash earnings, these will likely be funded by further equity raisings or increases in debt. As such, gearing of 35% is close to the upper range of our comfort zone – a 31% fall in prices (or a 2.6% rise in capitalisation rates) would push its gearing to 50%, meaning its bankers would likely demand an equity raising.
However, such an outcome appears remote at this stage with long term interest rates at historically low levels and expected to remain there. If you’re looking for a reasonable (unfranked) yield that will grow 3% each year for at least the next decade, this float might be of interest. However, we require a higher yield and a reasonable discount to net tangible assets (NTA) before becoming interested and so, while we will keep monitoring Viva REIT, we won't be adding it to our coverage list for now.