Cracks are beginning to show in a favourite group of shares many Australian investors flock to for dividend security – the Real Estate Investment Trusts, or REITs.
Cracks in the REIT Sector
“The (REIT) space is at an interesting juncture, with some dispersion in returns for the first time since 2011” says Hugh Dive, Senior Fund Manager at Aurora Fund Management (AUP).
This juncture is becoming more obvious in the share prices as some REITs such as BWP Trust (BWP) have recently made new highs while others have continued to slide lower throughout 2016 so far.
Last week we looked at Cracks within REITs, which showed some of the worst performing REITs on the ASX being the companies dependent on development profits or trading profits. This is of little surprise to some, especially after the Australian Bureau of Statistics announced last month that the Sydney property market fell in the December quarter of last year – that was the first fall in the Sydney property market since 2012.
REIT Rise Over?
“(Australian) residential construction is viewed as having peaked with apartment oversupply across Australia” says Vincent Cook, Senior Equities Analyst with CBG Asset Management (CBC).
There are similarities in the REITs that have continued to perform well. Dive says they have focused on investing in trusts that “hold higher quality property assets and are backed by recurring earnings, rather than development profits”
One example that has performed well for Dive at AUP is “Investa Office Trust (IOF). We saw that IOF was a well-managed trust with fewer earnings risks than some of their office trust peers. We also viewed that their assets would be attractive to foreign investors looking for stable yield and were being undervalued by the market.”
Externally-Managed Property Trusts as Take-Over Candidates
Interestingly Dive views “IOF as one of the last externally managed Property trusts was also viewed as a prime takeover candidate for other trusts looking to increase assets under management and is currently the subject of a takeover by rival Dexus (DXS). IOF has returned +14% since we added it in May.”
Cook at CBC took a similar insight to the externally managed Property Trusts. Galileo Japan Trust (GJT) is up strongly because of the take-over offer and Cook’s view is that Astro Japan Property Group’s (AJA) recent strong performance is also associated with AJA being one of the last externally managed REITs.
Quality in Tenants
Dive has been focused on REITs with “recurring earnings, rather than development profits and as such one of our largest overweights has been SCA Property. Over the past year SCP has been re-rated by the market as it has delivered solid but unspectacular returns from their portfolio of solid but unspectacular neighbourhood shopping centres.”
“We viewed that the market was undervaluing the quality of the trust’s earnings and the stability afforded by very long leases (average term 11.8 years). We see that in an economic downturn, food and liquor sales are more stable than apparel sales and development profits. Similarly we have been invested in BWP based on the same theme, but no longer have a position as the trust traded too far above our valuation.” Says Dive.
Cook notes a similar focus on these top performing REITs (SCP and BWP) with a common theme of long-term leases from defensive industries where the expiry risk is low, but so too is the rental growth of around 2-3%, what Cook calls ‘boringly slow’.
REITs to Avoid
Dive has Actively Avoided “trusts whose earnings were dependent on development profits or trading profits.”
Dive notes that many investors in these trusts have been relying on the development profits to bolster earnings. These development profits are effectively one-off profits, something Dive values around 1-2x times earnings. But the sector has been massively over-valuing this development activity of the REITs somewhere between 14 and 16 times earnings.
“We sold Cromwell (CMW) as we viewed that the Valad Europe acquisition not only exposed the company to a property market outside Australia (which has historically has been a poor decision for Aussie LPTs), but it decreased earnings quality and dramatically increased gearing. Similarly we have avoided both Mirvac (MGR) and Charter Hall Group (CHC) due to concerns about the proportion of earnings supported by development profits in an Australian property market that was close to a peak.”
Cook’s view of the REIT sector is that it’s “difficult to see rental growth for the next 1-2 years ahead. Therefore the growth per share is muted. Plus the whole universe (REITs sector) is trading at a premium of 15-20% to NTAs (Net Tangible Assets).” Cook is not currently holding REITs.
Opportunities
While Lend Lease (LLC) is not a REIT, Cook notes this is an opportunity for Australian investors in the property space on the ASX.
LLC is a well-run business that has seen a lot of growth from the residential sector in Australia but is invested ahead of the curve. LLC has pre-sold several billions worth of apartments with buyers sitting on 10-20% capital gains. With the residential cycle behind Australia Chicago and New York, LLC are reinvesting overseas with a focus on Chicago and New York where LLC is participating in Join Ventures for their own projects, with the first pre-sales due in the second half of the FY. LLC are focusing on large regenerative projects (like Barangaroo in Sydney) in Singapore and Malaysia and UK apartments that have provided a strong track record that are often 95% pre-sold”
