Listed property securities are unlikely to quickly return to their once exalted status.
However, the AMP’s chief economist and strategist, Dr Shane Oliver says they are showing signs of having bottomed.
The credit crunch is gradually fading, funding risk is now low, gearing has been reduced, Australian REITs are trading at a huge discount to net tangible assets and they are offering very high yields.
As such they offer attractive medium term returns, particularly given Australian REITs are at levels last seen 25 years ago.
Unlisted non-residential property valuations face further downside but the recovery in listed property securities and their recapitalisation is a positive sign.
Here’s Dr Oliver’s report
Listed property securities (or real estate investment trusts, REITS) whether in Australia or globally have been the worst affected asset class throughout the global financial crisis.
From their highs in 2007 to their lows in March this year, US REITs had a 77% fall and Australian REITs had a 79% fall.
This compares to top to bottom falls in global and Australian equities of around 55%.
Thankfully, with the gradual return to investor confidence, listed property securities are now showing signs of recovery.
In fact they have had very strong gains over the last three months (up 61% in the US and 39% in Australia), but still remain a long way from their previous peaks.
In fact, Australian REITs are still trading around levels last seen in 1984!
Listed property securities fall from grace
Until a few years ago, listed property securities had long been a favourite of investors reflecting their high returns, high yields backed by property rental income, their tax transparency and their perceived attractiveness as a highly liquid proxy for directly held property.
Many investors saw them as an alternative to cash or government bonds.
This enthusiasm was rewarded with very strong returns.
For example, over the 20 years to December 2006 Australian REITs returned 13.4% pa, versus 11.4% pa from Australian equities and 10% pa from Australian bonds.
However, rising levels of gearing, increasing offshore exposure, rising exposure to non-property income and industry consolidation led many to start questioning the ongoing attractiveness of Australian listed property trusts about five years ago.
Subsequently, 5% or less distribution yields then left them vulnerable going into 2007.
From 2007, listed property securities globally and in Australia started to come under pressure.
The sub-prime mortgage crisis turned into a credit crunch making it difficult for highly geared listed property securities to roll over any maturing debt or to offload properties in order to reduce gearing.
This turned into a rout in 2008 as the full force of the financial crisis hit and the very existence of some REITs was called into question.
Forced cuts to distributions have also accentuated the weakness.
Quite clearly, listed property has turned out to be far more risky and its income flow far less stable than had been assumed.
The nearly 80% slump in listed property securities has obviously harmed investor confidence in the asset class such that it will be a long time before they retain their once exalted status.
The further increase in the concentration of the Australian REIT sector, with Westfield accounting for nearly 50% of the index and just three stocks accounting for 70% of the index, along with the increased offshore exposure of the trusts, also adds to the case for investors to rely more on global listed property securities.
Ideally, the Australian sector needs to return to a greater focus on managing properties in less geared, less complex structures.
However, notwithstanding these issues there are good reasons to be believe that the worst is behind us and that listed property securities will continue to recover.
Reasons for optimism
There are four main reasons for optimism.
Firstly, the credit crunch is gradually fading.
Credit spreads are narrowing, economic conditions are showing signs of improvement and lender confidence is gradually improving, all of which should over time gradually start to ease the financial pressure REITs face.
In any case, the major Australian REITs have a very low amount of debt to be rolled over during the next year, and so funding risk is low.
Secondly, the sector has been able to reduce gearing by raising equity capital.
Australian REITs have raised nearly $14bn since September.
While this has been concentrated in the big trusts, they cover 90% of the index.
As a result, and despite property valuation write downs, gearing has actually fallen to its lowest level in four years on a weighted average basis – from a peak of around 36% early this year to around 31% currently.
This has substantially reduced the need for asset sales – forced or otherwise – that was hanging over the whole nonresidential property market; this could have had the effect of creating a downwards spiral as it would have placed valuations under more downwards pressure.
Thirdly, while downside exists to underlying property fundamentals and valuations, this is arguably already reflected in listed property security valuations.
Despite the rally in the last three months the Australian REIT sector is still trading on a 49% discount to the value of net tangible assets, which is still close to an historical record.
As can be seen in the next
