Value.able: Roger Montgomery

It can be more profitable to own a modest steel shed than a glitzy skyscraper

Areal estate investment trust, or REIT, is an entity that owns income-producing real estate. Think of a managed fund that concentrates on property rather than stocks and you have the idea for a REIT. They offer investors a partial interest in the rental income, capital appreciation and/or development profits of a variety of property classes, from residential to industrial.

Property categories include commercial (which encompasses the sub-categories leisure, retail, office, healthcare, industrial and hotels) and residential. And, of course, there is rural or farmland. The big names in property REITs in Australia include Lendlease, Mirvac, Stockland, Westfield, GPT, Scentre, Vicinity, Goodman Group and Dexus.

The obvious benefits of REITs include diversification through a low correlation with the broader market (although that might arguably be untrue most recently), income source diversification and stability, and a possible hedge against inflation. Listed REITs also offer the immediate benefit of liquidity.

But there are downsides. Management can travel “off-piste”, with debt-fuelled expansion aspirations ahead of the GFC bringing many REITs to their knees.

Another downside more relevant today is the end of a 35-year decline in global interest rates, which has been a tailwind for asset values globally.

Property investors must ignore all the talk about a shortage of land, net migration and Chinese demand. And rural property investors should be cautious about talk of the rising Asian middle class and its appetite for protein and the westernisation of tastebuds. These same arguments were used to promote rural property in Omaha in the 1960s! Value drivers are typically CPI, market rent reviews, vacancies, refurbishments and the difference between property yields and bond yields.

It is vital that investors understand the financially damaging implications of rising interest rates. In July 2016, US 10-year Treasury bond rates fell to 1.36%, their lowest level since 1773, when Captain Cook first crossed the Antarctic Circle. Since then rates have risen to 2.61%, raising the cost of funds for banks, which pass these costs on to borrowers.

At the same time higher bond rates led to increased discount rates (known as capitalisation rates in property circles) – the rate used by professionals to calculate the “present value” of future rental streams from a property. When discount rates rise, present values decline, meaning the value of those future income streams in today’s dollars is less and so the property is “worth” less. Indeed, it is quite possible the $4.7 billion of revaluations in the listed

REIT sector for the six months to December 2016 represents a peak.

The change in direction for interest rates is occurring after 35 years of asset-inflating declining rates, which have conditioned investors into believing the mantra of many property bulls that rates will stay lower for longer and asset prices will remain elevated.

But speculative bubbles are appearing in everything from fine art and wine to collectible number plates and high prices, along with record low yields, will ensure investors lock in inadequate returns for many years if not a lifetime.

Irrespective of whether interest rates are rising or falling there are some basic economics to be aware of. The most attractive economics can be found where

land, rather than the building, comprises a high proportion of the total value of the property. While there are tax advantages related to depreciation of buildings, the long-term economics of a high-rise office tower – where land is small and the building large – are undesirable. This is because buildings date and as newer buildings compete for business top-tier tenants move.

Buildings move too, from A grade to B grade and then C grade. As they age they become more expensive to upgrade and raise to a standard suitable for toptier tenants. Left to date for too long and landlords (that’s you if you are an owner of units in the REIT) may discover that rents from second- and third-tier tenants are declining and that the demolition or replacement of a building is too costly.

The art deco-inspired Empire State Building stood as the world’s tallest building for nearly 40 years, from its opening by President Hoover in May 1931. And while the building became famous two years later for being the scene of King Kong’s death, it failed to generate a profit until 1950.

In 1951 it was sold for a world record price of $US51 million and it gradually began to date. Between 1993 and 2011, 6500 windows were replaced, 32km of fibre optics and copper cabling was retrofitted and an energy-efficiency retrofit program was completed. The elevator system was modernised for the second time, the first being in 1966, and in 2010 a $US550 million renovation commenced, without which the building’s current popularity with tech companies would not exist.

Owning office buildings over the long term is an expensive exercise, with much of the rental income required to be reinvested for maintenance and upgrades. Any long-run economic benefit comes from the land underneath.

Tenanted industrial property, on the other hand, enjoys much more attractive economics. It is located on a relatively larger piece of land, with little more than a steel shed sitting atop, and owners benefit from much lower maintenance outgoings and relatively cheap replacement costs.

❶ Bunnings Warehouse Property Trust

The trust owns 80 warehouses enjoying 99.9% occupancy. Annual rents amount to $150 million and the weighted average lease expiry (WALE) is 5.5 years. Importantly, however, the WALE has been declining from 5.9 years on June 30, 2016, and 6.4 years on December 31, 2015. This is important because it is expected that several shorter-lease properties will be vacated as Bunnings moves to relocate to now vacated Masters locations. More than 23% of the portfolio expires over the next three years and while the management has outlined longer-term alternative uses for various assets, the risks have increased. Five properties have already been vacated, representing nearly 7% of annual rent. A further 16 are expected to be vacated as Bunnings relocates to preferred locations left by Masters. While capitalisation rates on newer properties have compressed in the low-interest rate-environment, this will change and, combined with the shortening lease expiry profile, it increases the risks.

❷ GPT Group

❸ Stockland

Retail sales have been grinding lower generally thanks to a weaker currency and tourism.

Low wages growth and already record high debt levels are offsetting any wealth effect from rising property prices.

Increased competition from international hard discounters in the fashion and supermarket sector are also pressuring margins. Apparel makes up almost 30% of rents in regional malls and

Australian retailers face an ongoing threat from the likes of Zara, Uniqlo,

Topshop and H&M. More importantly, the size of these international operators allows them to negotiate lower rents that are generally around half those of local operators.

And all this is occurring before Amazon arrives in Australia to unleash the kind of offers that overseas consumers have been enjoying for years. Retail landlords and retailers themselves have described December and January in generally weak terms and further insolvencies, such as Marcs, Rhodes & Beckett, Pumpkin Patch, David Lawrence, Howards Storage World, Payless Shoes and Herringbone are expected to weigh on sentiment, even though the gross lettable area of these operators is less than 0.5% of their totals. GPT noted that “retailer profitability will remain a headwind”.