After The Carnage: Australian REITs Post-GFC

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By Greg Peel

For 15-20 years prior to the Global Financial Crisis, notes JP Morgan, the endearing attraction of Australian listed real estate investment trusts (A-REITs) was that they provided similar total returns for investors (capital growth plus yield) as listed companies but with half the price volatility. But when the leverage bubble burst in 2007, the A-REIT sector was thrown into chaos.

Some did not survive, but for those that did the post-GFC period has been one of reducing debt and offloading assets at a time when debt costs were elevated and asset values were falling. It has also been a time of “coming home and getting reset”, as UBS puts it, as locally-based REITs have moved out of riskier offshore properties in their portfolios and reinvested into the relative safety of local properties.

The flipside of this pullback to home has been on the debt side, where A-REITs are now borrowing from cheaper offshore sources to load up on local assets rather than borrowing from Australian banks to buy offshore assets as had previously been the case. JP Morgan notes that 62% of the $45bn of outstanding debt held by the A-REITs in the broker's coverage universe is now offshore based.

The best news on the debt front, however, is that A-REITs are now on average only 29% geared with interest cover from FY11 forecast earnings reaching 3.4x, as JP Morgan notes. This is a far cry from GFC conditions, when gearing levels in excess of 80% brought down some players and interest cover covenant breaches were plentiful. The situation has continued to improve through 2010, and the good news on the asset front is that values are expected by JPM to rise by 2-3% over the coming year.

It would appear the commercial property crash that many had long predicted as a lagged response to the GFC is now no longer a major concern.

Refinancing risk is also reduced with loan maturities now averaging only 2.8 years, which JPM actually suggests is “too short”. But duration risk is nevertheless much reduced now, and the broker notes its A-REIT universe has raised $6.1bn of new loans year to date. As simple lending availability wanes as a concern, attention now turns back to the cost of that debt. The old rule of thumb here, which the broker believes is once again applicable, is that every 10 basis point move in the ten-year government bond rate equates to an inverse 1% valuation movement in a REIT. And the local ten-year yield has fallen 100 basis points in the last six months.

The bottom line is that it seems the A-REIT market is largely “back to normal” in an old-fashioned sense, looking more familiar on not only a pre-GFC basis but in a pre-debt-binge-that-got-us-there basis. This also means that the rebound from the March 2009 market lows which provided 18% outperformance of the A-REIT sector over the general market, including 9% in 2010 to date, is now largely over, according to JP Morgan. From here, the broker expects total return performance to be more in line with the general market.

The beta value of the A-REIT sector has moved back to its long-term average of 0.5 (which implies A-REITs will move in price on average by half the value of the All-Ords in either direction – that which makes REITs traditionally a defensive investment). Because A-REITs have now been structurally simplified, JP Morgan is “cautiously” reinstating the argument that forecast risk-adjusted returns for FY11 provide a traditional reason for holding A-REITs in a portfolio.

The recent reporting season provided the opportunity for analysts to reassess their A-REIT forecasts. UBS notes that the sector's earnings performance in FY10 beat the analysts' forecasts by an average 2.8%, and that FY11 guidance was a further 1.0% above the analysts' previous numbers. Residential conditions locally proved to be even stronger than UBS' above-market forecasts, and fund managers are back raising capital earlier and in greater amounts than the broker had thought possible in the wake of the GFC.

In making its valuation calls for FY11, UBS is focused on improving trends on the earnings line as debt reductions begin to flow through the numbers, offset by the relative dilution of earnings provided by exiting higher risk/reward offshore assets into lower risk/reward local assets. UBS is in agreement with JP Morgan in that A-REITs have now “moved up the defensive list” following the difficult work of restructuring during 2009. This means REITs will “outperform” in choppy markets (which basically means won't drop as much if the market takes another short-term dive) but underperform in a stronger market, delivering a “solid” risk-adjusted return.

Citi is also keen on A-REITs in FY11, suggesting there are now “clear opportunities” to buy names which are exhibiting earnings growth at a reasonable multiple.

So the next question is, which A-REITs are the better value within the sector?

Among the more active trusts, Citi's top picks are Stockland ((SGP)) and Goodman Group ((GMG)) while Dexus Property ((DXS)) is the winner among the more passive trusts. On the other hand however, Citi believes there's nothing wrong with CFS Retail ((CFX)) and GPT ((GPT)) other than they are already overvalued. The broker has Underweight ratings on these two.

UBS also likes Goodman, and adds Westfield ((WDC)) as a preferred investment with Mirvac ((MGR)) looking good on relative value.

While being upbeat about the A-REIT sector, JP Morgan believes that the market is continuing to run somewhat fearfully into the more defensive REITs – the “passive rent collectors” – at a time when active earnings recovery is improving. This makes the passive trusts overvalued and the active trusts undervalued. After an extensive reassessment post the reporting season, JP Morgan elected last week to make a slew of ratings changes.

Among the bigger trusts, the broker has pulled Stockland and ING Office ((IOF)) back to Neutral and downgraded CFS Retail, GPT and Bunnings Warehouse Property ((BWP)) to Underweight. In the smaller space, Centro Retail ((CER)) and Valad Property ((VPG)) have also been pulled back to Neutral.

On the flipside, the broker has upgraded Charter Hall Retail ((CQR)) and Abacus Property ((ABP)) to Overweight.

Aside from the above, JP Morgan also has Westfield, Dexus, Australand ((ALZ)) and ING Industrial ((IIF)) on Overweight, Goodman Group and Charter Hall Office ((CQO)) on Neutral and Mirvac and Commonwealth Property Office ((CPA)) on Underweight.

So a quick comparison shows a reasonable amount of agreement among the above three brokers, with Goodman and Stockland contentious on either Buy or Hold, and UBS and JPM in disagreement over Mirvac. Expanding further into the complete FNArena broker database shows an extended argument over Mirvac given a Buy/Hold/Sell ratio of 3/4/1.

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