Listed property trusts are basking in the limelight, but dark clouds are gathering, reports John Collett.
Who needs tech stocks when boring old listed property has given double-digit returns for the past three years?
Listed property used to provide a shelter in tough times, delivering a steady 7-8 per cent yield with modest capital growth. But with the kind of returns investors are enjoying on their capital, they could be forgiven for thinking listed property is a "growth" investment.
Beware. Few are ringing the alarm bell just yet, but investors should know that the nature of the sector is changing. Some of those changes include higher exposure to offshore property (and associated exchange rate risk), and higher levels of debt to finance its frantic merger and acquisitions activity.
Investors, stung by the worst investment market performances in at least a generation, have been rushing into property because of its well deserved reputation as a defensive play.
The sector is awash with money and is itching to do something with it - especially while the good times last. The problem for the trusts is that there is simply not enough quality properties in Australia to satisfy the investor demand for bricks and mortar.
"It's hard to get assets [property], so they're cannibalising their neighbours," says Howard Brenchley, who runs the APN Property for Income Fund. Several trusts have bid for, or are circling, the property assets of a weakened AMP.
Frank Lowy's Westfield Trust is in the process of snapping up AMP Shopping Centre Trust. Stockland Group is bidding for the AMP Diversified Property Trust. There's also Investa Property Trust, which is bidding for Principal Office Fund.
That's great news for the analysts, brokers and their employers - firms that earn fees from advising on the deals - but where does it leave the investor?
"It puts pressure on management to deliver," says Andrew Parsons, the head of real estate securities at Lend Lease. "If they don't, they know they'll be vulnerable to corporate play from stapled vehicles."
The trusts doing most, but not all, of the acquiring are the so-called "stapled trusts". The biggest names in stapled trusts are Stockland, Investa, Mirvac, Centro and James Fielding.
Stapled trusts work in this manner: shares they own from the property management company (paying dividends to their investors) are "stapled" to the units from the passive property side of the business, which pay distributions. The two - the shares and the units - can't be separated.
Stapled trusts have a cost advantage over their externally managed counterparts. Some stapled trusts earn an increasing portion of their revenue from activities other than their more traditional role as landlords who collect rents and manage properties. In addition to a passive property portfolio, stapled trusts may be involved with high-rise, off-the-plan apartment developments, or running property syndicates and earning management fees on them. There's nothing wrong with that - it can, after all, add to the trusts' earnings - but investors should be aware of what their trusts are up to.
One problem, as Parsons sees it, is that the big trusts are taking on debt to help pay for their acquisitions. The debt-to-asset ratio for the sector is more than 30 per cent; that's up from 12 per cent in December 1995, and virtually nothing a decade ago, when the trusts first forged a reputation for being reliable investments.
Brenchley says the acquisitions are being made at what may well be the top of the property cycle, and some trusts are paying top dollar for their acquisitions.
"Property is a low growth asset with steady income and that's its major quality," he says, adding that trusts branching into these other activities are increasing their risk profile.
He says investors need to ask themselves whether they want a good strong rental flow from a trust or whether they are prepared to take on the added risks that come with property developments and funds management.
Some trusts are being forced to look offshore for property due to the lack of available quality domestic property. Offshore property accounts for about 30 per cent of the sector's assets.
Parsons says if the Australian dollar keeps rising against the US dollar, there will be "downward pressure on valuations for the sector". That's industry-speak for a falling share price. Although the income from offshore property is hedged for shifts in the exchange rate, the capital is not.
"The debate, as always, is mostly about good management versus bad management, and the performance of the underlying property market," says Parsons. It's not so much about whether the trust is stapled or externally managed, he says.
Some of the best performing trusts, over the long term, operate under the externally managed model, Westfield being one of the best-known examples.
Westfield Trust holds the property assets, earns the rents and pays its unit-holders distributions. Westfield Holdings manages the trust's assets and the trust itself, earns management fees, and pays dividends to its shareholders. They are not stapled. The reason for their success is the quality of their management, says Parsons.
However, the sector today is riskier, says Parsons. It's not because the stapled trusts are diversifying, but due to the gearing and the currency risk they have taken on.
Mark Steinert, head of real estate research at UBS Warburg, says the experience for investors has been good, but, he stresses, it has been a good environment: a strong economy and falling interest rates.
"In more difficult times the risks can change quickly," he says. "We are not too concerned at this stage, because we continue to think that the outlook for the sector is reasonable."
The rise in the unit prices of the LPTs has seen the yield for the sector (income as a percentage of the unit price) come down to 7.3 per cent from yields above 8 per cent. When the stockmarket recovers, fund managers will start rotating some of their funds from the LPT sector into the so-called "growth" stocks - those whose share prices do best when optimism replaces pessimism.
"Real estate has been through a dream run in the past five years," says Parsons. However, big listed property trusts with offshore exposure are trading at historic highs, he says. Parsons says investors have high expectations for the sector based on past returns and investors are "underestimating the risks and overestimating the returns from listed property trusts".
Brenchley thinks the real worry lies with the stapled trusts. He is concerned that the market has overpriced some stapled trusts in particular, and the sector generally.
"The sector has always been regarded as a nice defensive play, but if the bulk of the income is not coming from rents, that's going to bring more risks to the sector."
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