By Michael Doble
This article investigates the issues that have confronted the Australian Real Estate Investment Trust (AREIT) sector in recent times. Why has the AREIT sector suffered so dramatically in the current market down turn? Aren’t they traditionally classified as low risk investments? Will the sector face inherent structural changes in the wake of this down turn?
The AREIT market has not been spared from the market turmoil that has engulfed global financial markets over the last 18 months. Market participants are saddened by the absolute returns the sector has experienced and are concerned about the apparent increase in volatility. However, on reflection, it seems that this may have been inevitable given the diver gence in focus from property as an income- producing asset that engulfed most AREIT man agers’ thinking, which started to take hold from the middle of this decade. Now, as the dust set tles, there is an emerging sense of optimism about the future outlook as market participants recognise the recent performance history as an aberration rather than an inherent structural change.
It’s crucial to not lose sight of the fact that amid the market turbulence and sharp sell-off in AREITs, long-term property fundamentals remain staunchly sound. If the performance of the market was driven entirely by the property market operating environment (ie, an oversup ply of accommodation, massive vacancies, falling income levels and poor property manage ment) then we might agree that the ‘safe haven’ afforded by the AREIT sector had disappeared forever. Unlike the property crisis experienced in the early 1990s, which saw a fundamental breakdown in property fundamentals, today’s property fundamentals have proven to be remarkably resilient.
The 1990s property crisis was defined by soar ing vacancy levels, a steep fall in office rents, an easy credit environment and unstable retail and industrial fundamentals. In stark contrast, today’s property fundamentals are defined by more stable vacancy levels, capped supply as a result of tight credit conditions, buoyant rental income levels and generally well-managed prop erty. With sound property fundamentals in oper ation, we do not foresee a structural change in the market.
APN Property Group’s outlook is based on a strong understanding of the fundamentals of what a good property investment should be. From our perspective, property in its pure form is a low risk income investment. It is a low growth investment. Growth should merely mir ror the GDP or CPI of the local operating envi ronment. Investors who seek excessive growth from property are simply buying risk. The secu rity of earnings afforded by the legal obligation a tenant has to pay rent (detailed in the lease) is what affords property investments their defin ing characteristic of generating secure, sustain able cash flows. Property investments should be viewed as an asset similar in its fundamental characteristics to Fixed Interest investments.
It is APN’s belief that the safe-haven remains in AREITs. The reason the market sold off so aggressively was due to the ‘perfect storm’ of financial market factors in 2008 that was as much coincidence as anything. Of course, many groups did buy assets (most frequently operat ing businesses and many offshore) that were overpriced and risky. This has now been proven as we witness ongoing impairments to the writ ten down value and goodwill that was originally ascribed to these investments, an observation APN has been commenting on repeatedly for years. (Thankfully we have avoided investing in many of the culprits.)
AREITs have traditionally been categorised as a defensive style asset (ie, an investment that remains relatively stable regardless of the state of the overall equity market). Unfortunately, the shocking fall-out from the global financial cri sis, initially caused by the US sub-prime mort gage crisis, delivered a particularly painful blow to the AREIT sector causing it to behave in an uncharacteristic non-defensive style.
AREITs haven’t been the only defensive sec tor impacted by the economic downturn. Any stock with gearing has been impacted to some extent. Bank shares (which have also tradition ally been regarded as a safe haven for investors) have also been deeply affected by the global financial crisis.
Debt behind the mayhem
The real issue underlying the recent mayhem in the AREIT market has been debt. In the lead up to the global financial crisis, some AREITs increased their level of debt beyond prudent limits. When the global financial crisis hit last year, the non-bank lending markets virtually shut down, leaving bank finance as one of the few sources of debt. This naturally led to a scarcity of debt and one consequence of this lack of debt availability (coupled with market uncertainty, even fear) was that there were very few buyers of direct property. This uncertainty caused valuers to start writing down values (even without the normal requisite sales evi dence). Falling asset values and the burden of unexpected liabilities (arising out of debt and currency hedging) and the tightest credit mar ket (perhaps) the world has ever seen has kept the focus on financial risk. Because some AREITs had invested (and borrowed) offshore, the fall in the A$ increased their liabilities, put ting further pressure on debt and currency hedging covenants. Also, the most common interest rate risk management strategy (the interest rate hedge, whereby the borrower locks in a rate via a derivative contract) became an additional liability as headline interest rates fell. To top it all off, many groups were forced to raise more equity to help relieve pressure on debt covenants, which caused AREIT prices to drop further. The chart below reflects the rise in gearing over recent years.
Ability to service debt improves
The bizarre part of the debt ‘equation’ is that as interest rates have fallen, the ability of AREITs to service the debt has improved. They remain attractive investments. Indeed, as the global economy slows, property will emerge as the least leveraged to downside because it has the security of the lease. Assuming the tenant remains solvent, property cash flows are one of the most certain of the key asset classes. The key measure of a borrower’s ability to service its debt obligations is the interest cover ratio or ICR (that is, the available earnings relative to the annual interest expense). We estimate that the AREIT market currently has an ICR of 2.8 times. This is a secure position as low risk, steady property income can sustain modest ICRs relative to active businesses with more variable cash flows.
While there are anecdotal signs that the stock market may have significantly overreacted, the duration and severity of the economic downturn and its impact on real estate values remains to be seen. However, it is reassuring to see positive solutions being enacted to help restore overall economic strength, including lowering of inter est rates, the Government Bank Guarantee, the proposed Rudd Bank and the ongoing fiscal stimulus reaffirmed by the G20 leaders in early April.
The recent pricing and volatility of the AREIT market implies fundamental risk within the sec tor. It also implies a lack of understanding of the underlying or intrinsic value of the securities in the market. This is the classic point in the cycle when active investment management becomes imperative. Passively accepting the index returns through this period of volatility is a recipe for disaster. The current market volatility is more a function of broader financial market uncertainty than specific or micro stock issues. Interestingly, our conviction levels in the assessed values of the stocks in the sector have never been higher as we have greater informa tion from managers from AREITs to base a wider variety of valuation measures. We remain confi dent that markets will recover over time. Indeed, the last month has delivered some encouraging signs of the (tentative) return of risk appetite. In the US, some of the investment banks that appeared close to collapse last year have actually posted modest profits in the early part of 2009. In a time of low and falling inter est rates, AREITs remain an increasingly attrac tive alternative on many measures — particular ly on a risk-adjusted basis relative to cash and fixed interest investments. A simple analysis of the initial yield relativity between the AREIT sector (11-12 per cent yield) relative to cash in the bank (3-4 per cent yield) is testament to this view.
Finally, while we do not see major structural changes emerging from the recent market upheaval, we do see a steady return to property fundamentals driving the sector in future. The risky corporate earnings that have been central to undermining the quality of earnings from the sector have diminished due to the global slow down. Now chided by the market for these inap propriate investments, most managers that once extolled the virtues of the move to non-rent earnings are now actively reducing their signifi cance (ie, selling businesses and/or committing to more passive assets). We see this move as a major positive development for the sector as it will significantly reduce the risk profile of the sector. Accordingly, if there is a structural change that occurs it will be for the best. D
Michael Doble is the deputy chief invest ment officer of APN Property Group, a spe cialist real estate investment management company that offers a range of property based investments for institutions, super annuation funds and individual investors. Doble is a highly respected property figure within Australia and has more than 21 years experience in property valuation, consultancy and funds management.
1. Property investments are best described as:
a) An asset not dissimilar to Fixed Interest
investments;
b) A low growth investment;
c) A low risk income investment; or
d) All of the above.
2. AREITs have traditionally been
categorised as a defensive style asset.
What was the primary reason for AREITs to
behave so uncharacteristically in the
current market downturn?
a) Falling asset values and unexpected
hedging liabilities;
b) Falling asset values, unexpected hedging
liabilities and tight credit market conditions;
c) Falling asset values, unexpected hedging
liabilities, tight credit market conditions and
capital raisings; or
d) The sharp impact of falling bank shares.
3. As the global economy slows, property
will emerge as the least leveraged to
downside because:
a) Interest cover is greater than two times
for the AREIT market;
b) Property has the security of a lease
covenant, providing regular cash flow;
c) The Government Bank Guarantee and the
ongoing fiscal stimulus; or
d) AREITs will continue investing in corporate
earnings.
4. Some positive signs are emerging in the
market that bode well for the AREIT sector.
These include:
a) Low base interest rates;
b) Government fiscal stimulus package, low
base interest rates and an increased focus by
AREITS on corporate earnings;
c) Low base interest rates, the Government’s fiscal
stimulus policies, some US investment banks
posting modest profits in early 2009 and a return
by AREITs to property fundamentals; or
d) A fall in the Australian dollar.