Retail master trusts banking on stability

Listed investments might have helped retail master trusts ride the recovery faster than industry super funds but, as Damon Taylor reports, there remains a strong preference for the underlying stability provided by unlisted assets.

As the financial services industry heads towards the end of the 2009-10 financial year, the name of the game continues to be recovery.

Where 12 months ago investors were experiencing their fair share of nervousness, investment markets have been buoyant in their comeback and according to Stephen Hayes, managing director of Perennial Real Estate Investments, while gains made by property might have been less dramatic, it is nonetheless an area in which super funds should be reassessing their options.

Reflecting on what the property story had been over the last 12 months, Hayes said Australia had witnessed an economic slowdown without actually seeing a recession.

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“On the physical real estate side, which is obviously reflective of the unlisted property market, if assets have been well located then they’ve probably stabilised,” he said.

“Generally speaking, buildings have also remained very well let,” Hayes continued.

“There haven’t been too many supply concerns, and I’d say most prime commercial properties have proved very cash flow resilient.”

Hayes said the exception to the rule was Brisbane, where an office market turnaround wasn’t expected any time soon.

“But overall, valuations have been pretty reasonable and I’d say we’re around mid, or just below, mid-cycle prices.”

Leigh Gavin, senior consultant and head of property research for Frontier Investment Consulting, also held a favourable view of unlisted property and its performance through financial crisis turbulence.

“Our clients have had a pretty strong preference for unlisted property for five to six years now,” he said.

“At that time, we were attracted to the more stable earnings it could provide and we could see the LPT [listed property trust] sector becoming more and more like another sector of the ASX [Australian Securities Exchange].

“We made the decision that we would look for a ‘long road’ payoff and we certainly got that in 2008 and 2009,” Gavin continued.

“But even through the global financial crisis [GFC] we felt the valuation policies for most assets were dealt with pretty reasonably.

“Unlisted property, especially lowly geared unlisted property, fell pretty gracefully — particularly when compared with LPTs.”

Looking at the listed side of property, Hayes said that investment in LPTs had offered an unbelievably rocky ride. Fortunately, having come through the crisis, he could now see some pretty compelling pricing.

“Within listed property we’re really talking about the top 10 stocks because anything below that isn’t investment grade,” he said.

“But these stocks are now pretty well placed with regard to their balance sheets.

“There’s not a lot of refinancing going on and they’ve got pricing that looks reasonable compared to 12 months ago,” Hayes continued.

“The majority are trading at discounts to our own private market values, so you could almost argue that these top, 10 stocks are offering better opportunities than can typically be found on the unlisted side.”

Providing a bit of historical context for his comments, David Hartley, chief investment officer for Sunsuper, said that if you looked back to February 2007, LPTs were trading at around an 89 per cent premium to net asset value.

“Obviously 2006 was a fantastic year for LPTs and 2007 was when they peaked,” he said.

“But in the course of changing offices recently, I found a statement about why that was happening, about why LPTs were trading at a premium to unlisted.

“It was all about gearing and flexibility and so on, but I thought it was interesting that if you look back now, a lot of those practices were what brought listed property unstuck,” continued Hartley.

“At that time, LPTs were really only surviving at the indulgence of the banks but you could argue that the business model that justified them trading at a premium was really what brought about their downfall.”

The here and now

Switching focus to the here and now, Hartley said while listed property was not without its problems, people were conscious of recent history.

“From here, there are still some LPTs with issues but I think banks are encouraging them to pay down some of their debt,” he said.

“Some of the stronger ones sold down stock last year and now have capital as a consequence. And I guess the weaker ones are still struggling along.

“There’s a natural cycle through both sides of property, but when there’s no debt, it’s a completely different story,” Hartley added.

“It’s a completely different pattern of returns.”

Yet while investment markets might again be in positive territory, the property situation was a lot grimmer 12 months ago.

At that time, both the listed and unlisted sides of property were receiving a hammering and the question was whether super funds were able to not only weather the storm but also take advantage of opportunities as they were presented.

With the benefit of hindsight, Gavin said Frontier would definitely have liked to take more profit at the top of the unlisted market.

“But the thing with unlisted property is to do that, you have to be up a bit over the curve,” he said.

“In saying that, if you look at 2007 and the opportunities across all asset classes, there wasn’t a lot of value, just a lot of chasing the few opportunities that did come up, and then in 2009 that reversed — there were a lot of opportunities out there, but not a lot of money.

“Unfortunately, despite the opportunities in other asset classes, there just wasn’t a lot in the way of property bargains.”

Gavin said that if he’d been asked last year, he would have said that Australia was set to see good property at low prices for two to three years.

“But those sort of bargains never really came,” he said.

“We thought there might have been opportunities in the LPT sector as they were forced to sell, but most chose to raise equity instead.

“And while that wasn’t good for shareholders, it was probably a good thing for the market,” Gavin continued.

“There were a handful of transactions in 2009 at prices we thought were pretty generous, but even they didn’t involve local institutions.

“Most were already overweight unlisted property and doing their best just to hang in there.”

Echoing some of Gavin’s thoughts, Hayes said super funds would have taken advantage of as many property opportunities as possible.

“Ideally, they would have been buying with their ears pinned back,” he said. “But premium assets were rare and there wasn’t a lot of opportunity to take advantage of distressed pricing.

“Where there was the occasional asset that came up funds would have been buying, but you have to remember that at that point, we were in the depths of the GFC,” Hayes continued.

“The world was in a pretty dire place and it was a pretty fearful time.

“It would have taken being one of the very few with cash available and, more importantly, a lot of conviction to be buying at that point.”

Offering the super fund perspective on what the best approach might have been over the last 12 months, Hartley said Sunsuper had done its best to take advantage of buying opportunities as they came around.

“We looked at some of the capital raisings and we also put money into our unlisted portfolio as well,” he said.

“We increased investment in both sectors, but to be fair, there were probably opportunities in the credit area that we were pursuing with greater interest.”

Hartley said a joint venture Brisbane office development between Sunsuper and AMP had also been completed earlier this year.

“That building, within Brisbane’s Coronation Drive Office Park, was completed this year and is already pretty much fully let,” he said.

“I think the only thing left to be leased is the coffee shop down the bottom.

“So we’re pretty happy with that, but we’ve also got the feelers out looking for other opportunities as the market improves,” Hartley continued.

“That’s the point here though, I think there’s been a lot of people out there looking to take advantage of distressed holders, but with the support of the banks and some refinancing they’ve managed to survive.

“By hook or by crook, they’ve managed to hold on.”

Domestic equities

Yet in the aftermath of this financial crisis, it seems most institutional investors continue to retain a partial focus on what could be learned from the experience.

Within the realm of property, that experience has given rise to some strong arguments that listed property could no longer be seen as the ‘look-through’ vehicle it might have been in the past.

The proposition is that LPTs should be treated in the same manner as domestic equities, yet for Gavin, this isn’t quite so simple.

“If you look at what happened through this crisis, listed property behaved very differently to how it had in other crises,” Gavin said.

“In other downturns, LPTs generally held up quite well, but they didn’t this time because of high levels of gearing, non-property income and so on.

“Then when things did get tough and they tried to raise capital, many chose to offer shares at a 40 per cent discount to the current share price instead of selling an asset at a 5 per cent discount to current valuation,” he continued.

“If you participated then that might have been a good result for you, but otherwise that wasn’t the case.

“From our perspective, selling an asset would have delivered the fairer outcome and we’re not fans of [the] companies that chose not to do that.”

With stronger views on the matter, Hayes said anyone putting listed property in the same boat as domestic equities had little understanding of property securities.

“Listed property fell during the GFC because it was liquid and because of panic selling on the back of refinancing risk,” Hayes said.

“If you’re a commercial real estate landlord and you have debt on your balance sheet, then generally you’re going to be refinancing a portion every year due to commercial debt having a reasonably short duration.

“This refinancing process isn’t overly problematic in normal markets, but what happened within property investment markets happened through no fault of Australian landlords,” Hayes continued.

“It was on the back of poor lending and product packaging practices abroad.

“The credit crisis meant refinancing became problematic and it’s very difficult to value refinancing risk.”

Hayes said at that point, the market assumed the worst.

“And if you can’t pay back your debt then you’re at the mercy of your lenders,” he said. “That’s what the market was responding to.

“In saying all that, Australian commercial real estate landlords chose to carry the debt and should have been more prudent in understanding the risks.”

Most importantly, Hayes pointed out that such an unusual set of circumstances had all but disappeared from quality listed property securities.

“Balance sheets for the top 10 are in really good shape and refinancing isn’t carrying the same risk,” he said. “So rental cash flows and commercial real estate type returns, which are the sole purpose for being in listed property in the first place, are being priced on that basis.

“I’m expecting listed property to behave and react as it should over the medium term, and that will be reflected in shareholder returns over time.”

Alternatively, Hartley questioned the role of listed property trusts within an overall allocation.

“Going back 10 years, these trusts were that kind of ‘look-through’ vehicle, but they now operate to a very different model with a different risk and return profile,” he said.

“Not so long ago, a fund might have had a 10 per cent exposure to listed property, and if it had all been in Australia, that would perhaps have entailed a 5 per cent exposure to Westfield — a significant exposure to a single stock.

“Compare that to say a 25 per cent allocation to international shares,” Hartley continued.

“Within that, you might have 10 per cent allocated to the UK and Japan, so we’re talking about a fund having the same exposure to listed property trusts as they have in all of their UK and Japan shares.

“It’s just too concentrated and I wouldn’t be surprised if more and more funds look to having their listed property as a global mandate as a consequence.”

Gearing

Still only a short way into its recovery, the other element of property investment investors could now usefully take stock of is gearing.

Obviously, different investment strategies and risk appetites call for different approaches and that shall remain the case, but with poor property gearing policies raising concerns recently, it is pertinent to ask what is currently the optimum approach.

Gavin said that within the unlisted sector, gearing at below 30 per cent was what he considered to be appropriate.

“But for the most part, our clients are well below that and often below 20 per cent,” he said.

“LPTs are somewhat different and they’re on or around about 30 per cent, which I’d consider moderate gearing.

“Both sectors have gearing about where it should be now.”

On the other hand, Hartley said gearing strategies really depended on the super fund’s cash flows.

“It’s going to be different for every building and every opportunity out there,” he said.

“Some gearing does make sense, particularly within international investments, where you can borrow money to minimise tax burdens, but it has to be appropriate.

“Twenty to 30 per cent is probably reasonable right now.”

For his part, Hayes said he had never been an advocate of gearing with respect to commercial real estate.

“Within Australia, the reality is that it doesn’t make sense to have debt on a tax basis due to trust tax transparency,” he said.

“We’ve got an environment of relatively high interest rates that will probably remain that way for some time into the future, and while the margins on that debt will move up and down, carrying debt on a weighted average cost of capital basis simply doesn’t stack up.

“If you’re going to use debt (God forbid!) then the time to draw on unused lines of credit is when the market is in massive distress and at the bottom of its cycle and the cost of equity is prohibitive,” Hayes continued.

“But everyone seems to do it the other way around...

“The simple reality is that debt is risky. At the end of the day, it’s not your money and at some point you’re going to have to pay it back.”

Liquidity

So with property making steady gains from its financial crisis lows, the last impediment before investment is perhaps investors’ need to retain liquidity.

But while liquidity was an obvious concern for unlisted property through the GFC and an impediment to many super funds taking full toll of property bargains that were available, Hayes believes it is a constraint that has lessened and allowed funds to flow back into property as equity markets and other asset classes have rebounded.

“We’re probably seeing a little bit of that,” he said.

“I think we’re seeing some of the unlisted property funds looking to raise money, and many have been well supported by super funds.

“With current commercial real estate pricing, the returns for these long duration assets look compelling,” continued Hayes.

“The investment stacks up at the moment, especially in the listed market.

“So I can understand it if funds are looking to increase their allocations at this point in the cycle.”

Similarly, Gavin said that while transactions in the secondary markets were at 5 per cent to 15 per cent discounts not so long ago, those discounts were rapidly disappearing.

“Those discounts are now well below 5 per cent,” he said. “And in some cases they’re pretty close to unit prices.

“The sector certainly looks like it’s going to be well supported this year.”

Providing the proof for Hayes and Gavin’s reasoning, Hartley said he was confident that a lot of the stronger listed property trusts had cash now as well.

“Previous potential sellers are no longer as keen to sell,” he said. “They’re not selling anymore, they’re buying.

“It certainly seems as though liquidity has come back.”

As always, the key question is where to from here. Property, as with all investment markets, has begun a long period of recovery, and according to Gavin that recovery is tracking well.

“I think the property sector is reasonable value now,” he said.

“On the fundamentals side, the sector’s probably reasonable without being super compelling, and the cost of debt is a bit of a hindrance, with the four main lenders making it pretty uncompetitive.

“But property is benefiting from a few foreign probes that are likely to put upward pressure on prices, and on the unlisted side we’re recommending a gradual return.”

Hartley reiterated that Sunsuper would continue to have its feelers out looking for reasonable purchases.

“And we’ve identified a few of those,” he said. “Overall, we’re reasonably comfortable and currently a little bit underweight unlisted.

“We’re certainly looking at opportunities as they come up.”

For Hayes, the launch pad for a property recovery is already in place.

“It all looks fine,” he said. “Australia is pretty well placed in a global sense and our commercial real estate is looking reasonably healthy.

“I think we can expect a year of moderate to low growth in cash flows in line with inflation,” Hayes continued.

“And I expect office and industrial assets to maybe do a little better due to improving tenant demand.

“It may be a slightly tighter year than last year on account of government stimulus rolling off and higher interest rates, but I’m not expecting vacancy rates to rise, so I think we’re pretty well placed — valuations are pretty good, fundamentals are pretty good and so the outlook is pretty good as well.”