A-REITs: Hugh Dive Are they set to fall?

But this time it’s different: property trusts are on firmer ground than they were when the GFC hit

The recent performance of the Australian listed property trust sector, or A-REITs as they are now known, feels eerily familiar. From 2000 to 2008 the sector more than doubled as debt, overseas acquisitions and moves into funds management fuelled growth.

It was a disaster waiting to happen, which is why our special report from the period, “Are your property investments safe as houses?”, featured “sell” or “avoid” recommendations across the sector. We didn’t have to wait long for those fears to materialise. Within a year of the GFC striking, the sector halved and halved again as trusts jettisoned recently acquired assets, struggled to refinance debt and conducted highly dilutive equity issues.

More recently, the sector has undergone a remarkable recovery. Since the depths of the crisis the S&P/ASX 200 A-REIT Index has tripled, leading many investors to wonder whether another staggering collapse is now due.

To answer that question, let’s take a look back to the heady days of 2007 to see if the comparison is valid.

One of the main features of the pre-GFC period was that Australian property trusts were set on taking over the world. With the financial press and investors cheering them on, trusts were hoovering up property assets in Europe and the US. Centro Properties Group, for example, was dubbed “the Macquarie Bank of property trusts” due to its aggressive use of debt to create a global empire.

In 2007, more than 40% of the assets of Australian listed property trusts were located overseas, from apartments in Tokyo to industrial properties in Dusseldorf and office towers in Brussels. The rationale for such empire building was that listed property trusts could increase earnings per share by buying higher-yielding offshore properties using cheap, short-term debt sourced from wholesale money markets.

DANGEROUSLY EXPOSED

It also meant the trusts could show off shiny new assets in their annual reports and take analysts on exotic site tours. The GFC blew a hole of catastrophic proportion in that rationale. Management did not understand the assets they had overpaid to acquire and the leverage used to acquire them made the businesses dangerously exposed.

Between 2009 and 2014, the belated recognition of these facts saw billions in offshore real estate sold off, more than halving the sector’s foreign real estate exposure to around 21%. Most of that is now accounted for by Westfield’s trophy shopping centres in the US and UK and Goodman Group’s Asian distribution centres geared towards the fulfilment of e-commerce.

Unlike those properties bought in 2004-06, these are high quality, strategic assets that weren’t purchased to provide a short-term boost to earnings and distributions. That’s strike one for the argument that it’s 2007 all over again.

What about similarities in payout ratios? In 2007, on average the property sector was paying out 95% of earnings, with some trusts paying out over 100%. That meant maintenance capital expenditure was financed either by borrowing or issuing more equity, neither of which is desirable for long-term shareholders.

In the short term, a trust can distribute all its profits to shareholders and artificially boost dividends or distributions. The sugar hit can be sweet for the share

price but in the long run all companies need to retain earnings to maintain the quality of the assets owned by shareholders. If they don’t, earnings power and asset quality can deteriorate. NO CUSHION

Moreover, with many trusts distributing all their earnings, no cushion existed to protect distributions if market conditions changed. In 2007, conditions changed dramatically, leaving investors with significant cuts to distributions. Investa Office, for example, cut its distribution from 9.7¢ per unit in 2009 to 3.9¢ per unit.

Currently, the sector’s payout ratio is a more modest 82%. This allows trusts to pay for maintenance capital expenditure and incentives out of current earnings. That 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. That’s strike two.

Now to the big one: debt. Ten years ago, the sector was highly indebted and paying a high interest rate on that debt. “Innovative” trusts such as Centro were riding high, delivering earnings and distribution growth by buying assets around the globe. It was an arbitrage strategy, based on the differential between the higher rental yield on acquired properties and the lower rate at which they could borrow on the short-term wholesale money market. When Centro acquired a portfolio of 467 small shopping centres across 38 US states for $3.9 billion in April 2007, for example, management upgraded its forecast for 2008 financial year distribution growth to 17%.

REFINANCING TROUBLE

Longer-term funding was available but it was at much higher rates, which would not have delivered as much earnings growth. The flaw was the presumption that favourable credit conditions would continue. With longterm property assets being funded with short-term debt, the sector had set up a dangerous mismatch that was the source of refinancing troubles for many when the GFC hit. Centro Properties in late 2007, for example, needed to refinance $US5.5 billion ($7 billion) of debt due to be rolled over in a very challenging market.

Most trusts couldn’t manage it, which is why many were forced into administration or, as did Goodman, conducted dilutive equity issues as shareholders had to replace the debt that had become due with more equity.

Today the property sector’s overall gearing is relatively low at around 30% (debt divided by debt plus equity). Trusts are also generally paying a far lower rate for their debt than they were at the time of the GFC. The quality of the debt is also generally higher, with longer terms 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 2019-20. 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.

HIGH PRICES AT RISK

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.

That’s our strike three right there. The property trust sector does not face the same acute risks it faced a decade back. Debt is lower, rates are lower and there is no appetite for debt-fuelled expansion.

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.

Most of the stocks in the sector remain a long way from prices at which we’d be comfortable recommending new purchases but that doesn’t mean the sector is massively overpriced and redolent with risk. At least compared with 2007, this time it is different for property trusts.

Debt is lower, rates are lower and there is no appetite for debtfuelled expansion

Hugh Dive is an analyst at Intelligent Investor, owned by InvestSmart Group. This article contains general investment advice only (under AFSL 282288). To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.