The REIT Minefield

This story features GPT GROUP, and other companies. For more info SHARE ANALYSIS: GPT

The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

In December 2007 the Australian real estate investment trust (REIT) market fell apart. Analysts never saw it coming. It began with a near collapse of Centro Property Trust ((CNP)) and ended with a furious de-rating of the trust model – which includes infrastructure and other trusts – even before the words Global Financial Crisis had entered the investment lexicon.

The problem was that the model relies very heavily on debt in the form of investment gearing on top of initial equity. In simple terms, a REIT borrows money to buy a property and pays a unit holder in that listed REIT a distribution from rent received, net of interest cost. If all goes according to plan, the asset value of that property improves over time and thus can be “cycled”, meaning sold for a profit and the proceeds used to buy another property perceived as undervalued on distribution and capital gain potential. Improvements to properties are also often carried out.

A “winning” REIT investment for the unit holder is thus one in which attractive distributions are paid over time and the unit price of the trust also increases in value. Such an outcome clearly requires the careful management of debt exposure vis a vis property market cycles.

Which is why REITS were among the first victims of what was to become the GFC. History will tell us that the GFC came about due to the overabundance of cheap financing matched with increasing competition over assets of lesser and lesser real value. Balance sheets became stretched, and when the subprime crisis became the butterfly wings before the impending tsunami of a credit crisis, REITs were left high and dry with too much debt and a total lack of ongoing lenders.

This meant trusts needed to quickly sell assets to repay debt, leading to a collapse in asset prices and thus a self-perpetuating, double-whammy of a unit price devaluation spiral.

That credit crisis has now abated and the global economy is on a tentative upswing, with the Australian economy in particular in apparent rude health. Depending on previous gearing levels and asset quality, the strong have survived and many of the weak have fallen. Centro's case was one of too much gearing over low quality US shopping mall assets, in contrast to its role model in Westfield ((WDC)) which boasted conservative gearing over high quality malls. Centro has managed to stay with us but many have fallen, and all surviving REITs have been forced to go to the market for more equity to ensure that survival.

Investors could thus now be forgiven for assuming that where there was once disastrous de-rating of unit prices, there should now be a corresponding rapid rebound among the survivors, particularly as they now boast much lower gearing levels, lower valuation bases for their assets and decreased competition in the market (including consolidation – strong hands taking over weak). We may turn to the smaller of the two Big Four Australian banks as an example, which fell further in share price terms than the larger two on risk assessment, but then bounced harder when that risk diminished. Unfortunately it's not that simple.

For starters, the commercial property market can be divided into three specific classes – office blocks, retail centres and residential blocks. The three do not move in perfectly aligned cycles. Crash and recovery in business, consumer and dwelling markets undergo leads and lags. Then add in the fact Australian REITs also among them offer offshore exposure, most notably in the US. Recovery in each of the three classes on either side of the Pacific has not been homogenous.

The lack of homogeneity has only added to disagreement among analysts as to where an investor might best find upside value from here.

Macquarie suggests that locally-listed REITs are still struggling to recover compelling cashflow and earnings metrics while they continue to digest the levels of new capital they were forced to raise. Getting on top of significant unit holder dilution was never going to be an overnight proposition. To that end, Macquarie is currently forecasting a total shareholder return of 22.5% over the next twelve months for the ASX 200, based on an ongoing “V” shaped recovery, but only a 13% return for the REIT sector.

However, drilling down into the classes the analysts see “pockets of value”.

They believe a recovery in the office sector has begun, with lead indicators of share market pricing, business confidence and employment all in an upswing. But office has lagged both retail and residential. Australian consumption rebounded pretty rapidly with a little help from government stimulus, and the same was true in the residential market in general (higher rents flowing from higher house prices).

The two latter sectors will nevertheless be impacted now by rising interest rates, which will slow consumer spending and ongoing house price increases. Occupancy costs in both are currently at high levels, so the analysts foresee below average growth from retail portfolios and dampened demand in residential.

To that end, Macquarie has an Outperform rating in the office space on Commonwealth Property Office ((CPA)) and ING Office ((IOF)), and has just upgraded GPT Group ((GPT)) as well.

Conversely Macquarie has downgraded CFS Retail ((CFX)) to Underperform., along with Stockland ((SGP)) and Mirvac ((MGR)) in the residential space. Westfield remains on Outperform in the retail space nevertheless given its compelling value and upside potential in a US recovery.

Deutsche Bank, however, disagrees on all but Westfield. Deutsche believes the market is already pricing in too much immediate earnings growth potential in the office space, resulting in Hold ratings on CPA and GPT while IOF scores a Sell. On the flipside, Deutsche analysts don't believe the same can be said for Stockland (Buy) and they offer up Goodman Group ((GMG)) as another Buy recommendation.

GSJB Were has also been looking at earnings growth potential, specifically through examining PEG ratios rather than PE ratios, which means price to forecast earnings growth rather than price to forecast earnings. PEGs are not something analysts usually dwell on with respect to REITs given REITs by their nature trade on high multiples vis a vis low earnings (distributions cloud the issue). However in these less “usual” times, the PEGs are helping Weres analysts with their assessment.

The result is that while Weres currently only has Stockland on Hold, the analysts note PEG ratios would suggest a Buy. And, again in stark contrast to Macquarie, Weres upgraded CFS Retail to Buy last week.

So how is the humble investor meant to dissect this information? Perhaps the humble investor needs first to assess his or her own portfolio needs. If they include swift short-term capital appreciation, then analyst disagreement on REITs suggests a minefield. However, history suggests that investment in quality yield stocks is a successful long term play.

“Quality” yield does not by default mean “high” yield. It means a reasonable yield backed up by quality assets held on the basis of comfortable gearing. It must be noted that stock analysts rate stocks only on a six to twelve month basis despite discounting earnings forecasts well into the future.

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