Listed Property feature article

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The listed property shows new blossom

Everything old is new. It seems that the listed property sector is returning to its previous model and slowly becoming a defensive asset again. This has resulted in more positive adviser and investor attitude towards listed property, which is not to say that all bad apples have been weeded out of the sector. Benjamin Levy reports.

LISTED property is going back to basics. The 2007 investment approach of explosive growth, unsustainably high dividends, and excessive gearing levels that was shattered by the financial crisis has given way to what the sector was meant to be – a conservative, defensive growth asset offering steady, inflation protected returns.

As the sector shifts focus, it is beginning to once again attract the attention of financial planners looking for a steady income stream for retired clients and a viable alternative to the shaky performance of domestic equities.

But choosing what to invest in needs to be a careful exercise. Listed property groups with ongoing debt problems still exist and can yet prove dangerous to

investors, while others are too tied to the market to provide alternative returns for portfolios. The issue of excessive concentration in the domestic market continues to dog investors, while currency volatility in the Australian dollar threatens overseas income distributions.

In a sector where the research houses seem divided on where to place investors’ funds and cannot offer a clear approach, advisers need to carefully consider where the best opportunities can be found.

Back to basics The upheaval of the global financial crisis (GFC), which forced listed property funds to slash their debt, cut high gearing levels and lower high dividends,

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Listed property this year is down actually about nine per cent, [and] a fair bit of that is equity market volatility even though listed property trusts have reduced their volatility compared to the broader equity market,” McGrath says.

– Andrew McGrath

”

has sparked a return to conservatism in the listed property sector.

Gearing levels in property trusts, which were once as high as 40 per cent, have been reduced to a sector-weighted average of 28 per cent. Exposure to overseas assets has been reduced, and sources of funding have been diversified to cover bonds, US capital markets and the banks.

Property trusts are moving back to their core business of managing domestic property, according to co-director of Reliance Investment Management Andrew McGrath. Reliance is the fund manager of Charter Hall Property Securities Fund.

“The sector is back to its basics, back to being a defensive asset class, and that

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We recently had a new group come in and invest with us in our latest fund, and they spent six months researching us as a manager as well as researching the actual product.

- Jason Huljich

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will gradually be recognised over time as trusts deliver on what they’ve said,” McGrath says.

Defensive trusts are announcing four to six per cent earnings growth for next year. Despite still-visible GFC scars, the current positive reporting season should draw investors back to the listed property sector.

Research house Standard and Poor’s (S&P) most recent listed property review found the domestic sector in much better health thanks to the detoxing effect of the financial crisis.

“After going on a drastic debt diet, undertaking sizable equity raising and reverting to ‘back to basics’ strategies over the past few years, most of the [AsiaPacific] region’s Real Estate Investment Trusts (REITs) emerged from the financial and economic crises with stronger balance sheets and improved r isk profiles,” the report said.

The GFC also ser ved to get rid of underperforming property trusts that were badly structured and debt-ridden, leaving up to five large, clean, well structured property groups to choose from,

and the dealer groups are taking notice. ipac is using the listed property sector to provide a real income stream for its retired investors, according to ipac chief investment officer Jeff Rogers.

The amount of leverage which inundated the listed property sector pre-GFC prevented dealer groups from using the sector to provide an income stream for their clients.

However, large scale recapitalisation and equity raisings in the past few years has reduced the amount of leverage and re-established the attributes of real underlying property and rental schemes, allowing dealer groups like ipac a second look.

“It’s a reasonably high yield, sustainable in terms of good rental streams, but an income stream that one would expect to rise at least with inflation, if not a little bit faster over time,” Rogers says.

The retail sector of Australia’s economy is looking weak. The Reserve Bank has kept interest rates on hold since late last year as consumers refused to spend, and expectations that the Reserve Bank will drop its cash rate to stimulate the economy should fuel more investor demand for the defen-

sive exposure listed property now offers.

Some of the banks have already reduced their term deposit rates.

Fund managers have already started benefiting from increased dealer group interest in listed property as a result.

AMP Capital was recently placed on Count Financial’s approved product list.

Dealer groups connected to National Australia Bank and Westpac have also started adding property options to their product lists.

“In the last 18 months to two years, there was a lot of aversion to risk, a lot of people moving into just cash, which was pretty safe, but as you know you don’t get any growth in cash, just interest,” AMP Capital head of retail distribution Ben Harrop noted recently.

However, the confluence of factors leading to a more conservative investment strategy and playing to expectations of a ‘back to basics’ approach are also leading to projections of low growth in the next few years.

There are less high risk offshore investments, less development profit being earned, and fewer non-traditional retail

office returns with volatile income.

While it’s a perfect mix for producing income, retail investors hoping for the same “shoot the lights out” result that they experienced before the financial crisis will be disappointed.

Retail investors have some way to catch up on funds under management anyway.

Institutional investors placed $5 billion in new inflows into the sector last year.

Market volatility Market volatility is driving some financial planners to invest more in listed property than they usually would.

“We’re increasing our appetite for real assets – we reckon they represent good value over equities, especially for our more conser vative investors,” says Duncan Essery, financial planner at RI Advice in Surry Hills, NSW. RI’s asset sector includes global and domestic real estate investment trusts, as well as infrastructure. Strategically, their exposure shifts between 5 and 20 per cent and their exposure is currently at 10-14 per cent.

Importantly, Australian REITs are currently less volatile than growth assets such as equities, but with inflation-protected yields of 6 to 7 per cent. That allows Essery to treat them as a growth asset.

“If you get a greater return above inflation with half the volatility of the market, that’s a good thing,” Essery says.

However, some fund managers are concerned that listed property is too correlated with the share markets.

Listed property has been going up and down with the share market for the last six to nine months, and dealer groups and asset allocators are beginning to place their AREIT exposure into equity exposure instead of property as a result, according to Centuria Property funds chief executive Jason Huljich.

Many of those dealer groups, which include the banks and large institutions, are moving into direct property for their property exposure as a consequence.

However, while the whole sector displays unusual volatility in its daily capital price, it may be a reflection of unreasonable fears that listed property may once again become as volatile as it did during the financial crisis.

That fear, which some have branded as backward-looking, also fails to take into account the internal structure of many property trusts and the steps they have taken to recapitalise and fix their balance sheets.

“Because they’ve recapitalised and because they are focused on rental schemes, even though their price can be volatile in the short-term, I’d actually say that’s not a concern if you’re focusing on the income stream, provided that the income stream is sustainable,” Rogers says.

Reliance Investment is expecting retail investors to place more funds than usual in the REIT sector.

McGrath admits that there is some downside in the correlation between listed property and the share market, but still expects a lot of interest in listed REITs as deposit rates reduce.

“Listed property this year is down Continued on page 16

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Continued from page 15 actually about nine per cent, [and] a fair bit of that is equity market volatility even though listed proper ty tr usts have reduced their volatility compared to the broader equity market,” McGrath says.

“In a low growth environment – and we’re expecting the next couple of years to be fairly low growth – REITs should perform relatively well, so in this situation you’d probably have more than you normally would in a REIT portfolio,” McGrath says.

However, direct property will probably end up outperforming this year compared to the high volatility listed sector, because the valuations of direct property don’t move around as much.

Portfolio allocation Dealer groups need to be selective before investing in listed property. Just because the financial crisis knocked out several property trusts and taught a few harsh lessons doesn’t mean that the remaining ones are as good as new.

The listed property sector is currently split into three types of trusts. The most dangerous for investors are “the walking dead”, as Rogers colourfully labels them, with residual leverage and debt problems.

Barely surviving through the GFC, they are likely to stagger on until debt holders or the banks decide to call in their loans and shut them down, and both advisers and property trust managers should avoid them.

The second class are more traditional property structures that are closer to what the sector looked like ten years ago.

They focus on yield and income streams and s h ou l d b e us ed f or inc om e investors. The third class are much more closely correlated to the share market, have similar characteristics to equities, and will go up and down with the share market.

Dealer groups are performing significantly more due diligence on the sector these days to work out which is which.

“We recently had a new group come in and invest with us in our latest fund, and they spent six months researching us as a manager as well as researching the actual product,” Huljich says.

It’s a sign of advisers’ concerns that they are being as careful as that even when a reduced field of competitors has made it easier to pick out the winners.

“You have some pretty high quality groups left in this space, so now it’s a lot easier for these planning groups to identify the quality managers and who they should be investing with,” says Huljich.

Portfolio allocation becomes trickier when deciding over global REITs versus AREITs. The research houses and fund managers seem to be of two minds on the outlook for listed property, making it difficult to know which path to take.

ING Investment Management has anticipated a positive year for global listed property despite the debt crisis and Europe. Infrastructure spending on the few REIT properties in Japan damaged by the natural disasters there will boost economic strength in the Asia-Pacific region more generally, while quarterly returns of more than 8 per cent in the United States offers opportunities in another region, the fund manager said recently.

Standard and Poor’s weren’t nearly so positive, warning that the performance of most overseas funds is still constrained by global economic events despite small improvements. Only two global funds were upgraded out of 21 rated by the research house.

Morningstar would seem to be quite bullish towards domestic REITs at the moment, recently upgrading six of their 18 rated investment strategies. Most fund managers believe AREITs now possess attractive valuations, the researcher said.

Morningstar cited improved fundamentals and conservative investment positions across the sector for their positive performance.

That support comes with a caveat, however: Morningstar suggested only a

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I think sometimes people “forget that ultimately global REITs does not deliver what people would expect from a domestic REITs portfolio.

”

- David Curtis

Global real estate investment trusts did not suffer as much as their domestic counterparts during the GFC and recent capital raisings, reconstructed balance sheets and improving fundamentals meant that payment constraints were unwinding, the researcher noted in another report.

Co-director of Reliance Investment David Curtis says both global and domestic REITs are needed in a property portfolio.

“I think sometimes people forget that ultimately global REITs does not deliver what people would expect from a domestic REITs portfolio,” Curtis says.

The two sub-sectors offer their very different risk and return profiles, Curtis says.

Global REITs have been very popular among financial planners and investors in the last couple of years, but with the amount of money that has been poured into them, valuations in that sector have been pushed to unattractive levels, such that domestic REITs are becoming more popular.

Essery’s exposure to domestic REITs has been minimal in the past 12 months and they are just now shifting focus away from global REITs. “Twelve months ago we were quite bullish on the global REITs sector, and that was a good time to move into that, so what you saw there 12 months ago is probably what you’re seeing now in Australia,” Essery says.

Domestic REITs with quality property and clean business models are trading at massive discounts to net tangible assets, and running at yields of 6 to 7 per cent, making them attractive for Essery’s clients.

“We think it’s really good exposure for our clients to be getting into,” Essery says.

Exposure to global REITs has dropped from 40 per cent to 25 per cent recently.

Tossing up between currency and diversification

minor allocation role of five per cent for dedicated AREIT exposure in a portfolio.

Only one month earlier Morningstar seemed to go the other way, noting that global listed strategies were likely to pay out income distributions at the end of the 2010-2011 financial year.

REITs were created so investors who couldn’t afford to buy an entire property could still get exposure through buying property shares. But if investors don’t buy Australian REITs, they won’t be protected against Australian inflation and will be open to overseas problems.

Morningstar noted in their recent report that volatility in the Australian dollar earlier this year resulted in large losses on currency hedging, and income distributions suffered.

The problem was only likely to persist given the continuing instability in the value of the Australian dollar, Morningstar said.

“Currency exposure can create all sorts of issues on the actual return you end up getting,” Curtis says.

Investors are caught in a catch-22 when it comes to currency. Any returns on overseas REITs can be wiped out by moves in the Australian dollar if they don’t hedge their returns, but if investors do hedge their returns they have to fork out the money they’ve earned to cover hedging costs if the currency moves the wrong way.

The danger of ruining your returns by currency hedging increases when yields on listed property around the world are forecast to be low for the foreseeable future.

But abandoning global REITs for those reasons and investing only in domestic

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Listed Property REITs comes with its own problems, as well. The two stocks owned by Westfield make up approximately 40 per cent of the AREIT index.

A fund manager following the index may only be able to deviate by 3 per cent, but it would still leave them with a 37 per cent exposure to only two domestic property stocks.

That stranglehold makes it nearly impossible to achieve meaningful diversification for investors without resorting to overseas stocks.

But there are other ways to achieve diversification without going overseas.

Reliance Investment follows a benchmark unaware approach.

Fund managers wanting to concentrate on domestic REITs and still get diversification shouldn’t follow the index, McGrath says.

Managers who are benchmark unaware can overweight inflows into stocks that won’t make up a disproportionately large amount of the index, and with 40 investible stocks out of a total of 60 in the sector, there is plenty room for diversification, according to Curtis.

Investors and advisers may complain a lot about concentration and diversification in the domestic REIT sector, but they are going to have to wait for the fund managers themselves to do something to solve those issues. Most domestic REIT fund managers are still following the index.

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Where are REITs getting their capital?

DURING the financial crisis, listed property funds had to scrabble under the couch cushions to raise debt capital as the banks tightened the purse strings.

Drastic debt cutting measures and multiple equity raisings helped most REITs pull through the worst of the GFC, but now that markets have improved, many REITs are looking for debt funding once again. Where are they getting it, and have the conditions changed?

There are indications that the listed property funds have learnt their lessons from the debt crisis and are diversifying their funding sources.

According to S&P’s report card on debt credit trends on the listed property market which was released earlier this year, REITs that are looking to fund maturing debt in 2012 are now accessing the bond market to provide an alternative source

to the banks.

S&P called the move positive for credit quality.

REITs are also issuing their own corporate paper, as well as approaching super funds for debt funding.

The search for alternative sources like bonds and super funds for long-term debt is part of a move to shift the job of the banks from guaranteeing long-term debt to providing funding for the REIT development pipeline, according to S&P REIT credit analyst Craig Parker.

That shift would make the bank funding period less than two years in most cases, a scenario that would probably make both the banks and the property funds happy. “ The sources and the supply of credit has improved dramatically for REITs, and that’s critical because the pain was exacerbated by the fact that they had no alternatives during

the GFC, and that’s definitely changed and put the REITs in a much stronger position,” says McGrath.

Although market volatility has temporarily driven the listed property sector all over the place and caused some to fear about the high correlation between the share market and REITs, trusts have had no trouble at all sourcing funding of all kinds.

Property group Stockland raised funding for 10 years in the US bond markets last month.

But REITs that aren’t as big as Stocklands should be careful. “ The banks are more discerning in who they want to lend to, but our portfolio of rated REITs is strong and they will have the support of the banks. If you are a weaker REIT, one that we don’t rate, I’ve heard anecdotally that the banks are tr ying to reduce their exposure,” Parker says.

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