Property Trusts Still On The Nose

Sydney, Jan 29, 2008 (ABN Newswire) - Given the damage done to confidence by the travails of Centro Properties, MFS and Allco, it's no surprise that the once staid property trust industry is on the nose with many local investors.,

Gone are the days when they were just a proxy for interest rates and a nice defensive buy in bad times.

Changes to laws allowing internal management and administration, as well as allowing funds to get rid of outside trustees, and a huge push offshore in the past few years, has seen the nature of the industry change completely.

(Australian trusts have been the biggest investors in US retailing property over the past couple of years, according to some commentators.)

Not even the near death experience of Multiplex in its UK adventures, cautioned investors about the dangers of investing in a business that was highly geared, internally managed and depended heavily on economic growth on countries like Germany, Britain, the US and other parts of Europe.

There are still old fashioned trusts that invest in Australian property, and not much more. But there are those that invest in European office buildings, German housing, British commercial property, retailing and warehouses across the US.

The biggest operator is still Westfield and in many ways it is still the most old fashioned: After flirting with a division of its businesses into separate trusts, it merged them, internalised management and set about expanding deeper into the US and the UK, but didn't neglect its Australian and New Zealand heartland.

Investors in Westfield might have greater volatility from problems in US and UK retailing and economic conditions, not to mention increased currency volatility, but compared to MFS, Allco, Centro and some of the offshoots and Macquarie Bank and Babcock and Brown, investors are still buying into a shopping centre operator when they invest in the Lowy family vehicle.

But quite a few funds have become active dealmakers, trading assets (and incurring transaction costs), expanding (pre-Centro) with opaque accounts and transaction details long on promise but short on detail.

Others have simply plunged into markets like the US without wondering about the advisability of moving into a market as deep and as volatile as the US.

Every property trust with an overseas play has been hurt by the rise in the value of the Australian dollar over the last 11 months. That is not going to ease anytime soon with Australian interest rates at a significant premium to the US and Europe (3.5% and 4% respectively). The likelihood is for Australian rates to rise at least one more time this year. That will widen the margin.

According to Goldman Sachs JBWere, last year was a terrible 12 months for the property trust industry (also called by their US acronym, REITs or Real Estate Investment Trusts).

"The performance of global REIT markets in 2007 was abysmal. 2008 has not started any better, with the Australian REIT sector off 14.4%, despite a 6.8% rally on 24 January. The Australian sector yield of 7.5% is now back to a level not seen since 2004.

"Although there is still little in the way of valuation or transaction evidence, in our view many foreign non-prime assets are likely to see an imminent upward movement in cap rates of at least 50bp (or >7% in asset value terms). Australian non-prime assets should fare better, particularly in the Office sector, though some widening of the quality spread is warranted.

"Our total return forecast for the REIT sector in 2008 is 12-15%, comprising 6.5% yield and the remainder being capital growth. Based on the sector share price movements year-to-date of -14.4%, the composition of returns using 24 January as a base changes to a 7.5% income contribution and 19-22% capital growth.

"This is in line with our current 12-month-forward bottom-up sector valuation of a 22% discount to fair value.

"We do not view Australian-listed REITs as being structurally flawed and over time would expect that REIT performance should mirror that of the direct property market - with the variations of this premise being driven by those REITs with active businesses attached.

"A number of stapled REITs with active "other income" streams are trading at a discount to NTA at present, which we believe reflects both a written down NTA assumption and the market's view on likely operational headwinds.

"Over time we believe some sort of premium should again emerge, driven by management teams that can add value through capital initiatives (i.e. Funds Management, Property Services, Mergers&Acquisition, etc.) and strong operating performance.

"Given the recent volatility in the REIT sector (and the broader equities market for that matter), we acknowledge that some investors may be focusing their attention towards those REITs that offer higher yields, rather than greater total returns, given the volatility around share prices. The sector yield is now back at a level not seen since 2004 of 7.5%.

"The spread versus ten-year bonds has also turned positive again.

"For those investors chasing yield we would avoid some of the higher yielding REITs that present significant dividend-cut risk, such as the Centro stocks and some of the US-exposed REITs."

"The key catalyst for the recent marked correction is the trouble experienced by Centro Properties (CNP) and its managed vehicle, Centro Retail (CER). Worthy of note in the case of CNP is the impact having been exacerbated by the group's aggressive off balance sheet gearing and the inclusion of intangibles for lending purposes.

"There are two Centro issues that impact other REITs within the sector:

"1. As debt matured refinancing was unable to be secured; and

"2. The value of equity is being eaten away by declining US asset values and high gearing.

"At present increased funding costs are being driven through a lack of liquidity, which has then translated into margin expansion across the board (in some cases upwards of 200bp).

'If normality does not return to debt markets in 2008, this could potentially be offset by more US Fed cuts, bringing the net cost of borrowing back to more normalised levels. Alternatively, if stability emerges, margins may contract again with less Fed cuts coming to fruition.

"Those US-invested Australian REITs that are most exposed to movements in US asset values (and have significantly underperformed the index post the Centro downgrade) are those that are both highly geared and with little/no capital hedging."

Goldman said many of these trusts had a valuation gap that would be hard to narrow in present circumstances, without some help from factors like:

"Positive 1H08 results (including valuation data that supports current book values). Any incremental growth delivered through like-on-like income growth is also likely to assist.- A more stable credit environment or successful refinancing at modestly increased rates. - Consolidation within the sector."

The idea of consolidation is hard to see unless it is friendly and based on a very accurate due diligence.

The longer there's no move to consolidate this sector, the more investors can take it that even the various players remain suspicious of each other's balance sheet and asset values.

Once there are one or two deals revealed of size, then you could argue that the corner has been turned and confidence is returning. But being invested in an acquirer will take something of an act of faith for a while.

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