Welcome to the November edition of the Burrell Blog for 2017.
This month’s blog considers aspects of the listed property market, before an overview of current portfolio settings.
The listed property market is structured in the main as listed property trusts so called LPT’s or AREIT’s (Australian Real-estate Investment Trusts). Where a property business such as property development or aged care is carried on alongside the property interest, that usually is structured as a company alongside the trust and so the company shares and property trust units are “stapled”. Mirvac and Stockland are stapled securities.
In order to understand the listed property market, understanding of the physical property markets is useful. The relevant sub sectors are office, retail and industrial. In theory the value of LPT’s is equal to the value of the properties owned by the trust divided by the number of units on issue. Where the value of the properties is above the market price of the unit, buying should result in superior returns as the unit price tracks towards net assets (NTA). Likewise where the market price of the LPT is greater than the NTA of the underlying properties, a sell signal would be the starting point.
In 2007 the LPT property index was trading at 2400 whereas after the Global Financial Crisis, it had fallen to 600. Prior to the GFC, LPT management were talking up their prospects and when challenged about the market price being above NTA, justification was provided in better use of leverage, better development opportunities and better management. The comment that “it is different this time” is a warning to investors that those in the sector may have lost focus. Indeed that was the case and Australian LPT investors suffered large losses as some of the previous premium LPT’s such a GPT made a bad situation worse by entering the US market when it was trading at high prices, buying poorly and using excessive gearing. In March 2009 after the falls, LPT managers were quite downcast and when queried why the LPT market prices were less then NTA, excuses such as poor lending visibility and matters which had little to do with fundamentals were postulated. In truth, the LPT market was simply over valued in 2007 and grossly undervalued in March 2009. We’ve seen the index recover from 600 to around 1300 currently.
Calculating the NTA at first instance is relatively simple for investors because the LPT’s pursuant to the accounting standards generally revalue properties on a three year cycle and so the LPT has done most of the work in calculating the NTA. Burrells await the half yearly LPT announcements with interest and the movement in NTA for the LPT sector.
From 2009 to 2015, Burrells held the view that the reported NTAs were probably lower than actual NTAs. The explanation for this view was found in the methodology used by valuers whereby to value a property the net rental is divided by the capitalisation rate. Thus if the rent on a property is $500,000 and the capitalisation rate is 10%, the property is worth $5M. If the capitalisation rate is 5%, the property is worth $10M. It can be seen for each 1% change in the capitalisation rate, the property changes in value by $1M, so the property values are sensitive to capitalisation rates. The valuation formula is a simple metric whereby the present value of an annuity is equal to the annuity divided by the discount rate. PVA = annuity/discount rate.
Burrells view was valuers were slow after the GFC to reduce capitalisation rates from 7.5-9%, even though the risk free rate on 10 year bonds was reducing. That risk free rate fell from 6.5% to under 2.5%, so that one might have thought the capitalisation rate would also fall by 4%. In fact this process has had a lag of several years.
But where are we now? Well we are seeing capitalisation rates on Sydney office property, some as low as 4.5%. It seems we have moved from a situation where the true NTA may be higher than reported NTA to one where the true NTA may be lower than reported NTA! We understand that similar lower yields are applying in the valuations of retail shopping centres. “Property markets are overvalued: Waislitz” reported in The Australian on November 8, 2017. Mr Waislitz’ Thorney Investment Group reported “Thorney was selling more properties of late than we are buying, he said, warning that the nation’s residential and commercial property markets could be “10-20% overvalued”. “In general I think it is all overvalued “Mr Waislitz told the Australian.
Regular readers will be aware of your diarist view that long term interest rates both in Australia and overseas have bottomed and are likely to rise, perhaps at a faster pace than the central banks might acknowledge. A reason for this is once the central banks pull back from the markets, the markets will set their own rate and central banks will return to being more modest influencers. While there is debate as to how quickly the long term bond rate will recover, your diarist and our fixed interest desk have the view that a 1% increase over the next 12 months will not be unreasonable in the 10 year long term rate. Remember it is the 10 year rate which is the risk free rate for the purposes of valuing equities and property, not the short term cash rate which achieves much publicity on the first Tuesday of every month. In short, the valuers formula is assuming longer rates forever, when the correct formula for valuing future cash flows is to use the appropriate discount rate in each year or series of years. Thus the appropriate discount rates should be higher going forward in outer years. Based on the above logic, Burrells have lightened, particularly the index in the LPT sector given the likely increase in the long bond rate, the fact that the LPT sector was trading above NTA on average and that those NTA’s are more likely over stated than understated, although they require an adjustment for a development and fund management activities now carried out by some of the larger LPT’s.
Looking at the subsectors, the Sydney office market appears fully priced. Reports on the industrial sector are inclined to show that the LPT market has been cautious on growth for the Australian economy and so reasonable value exists in the industrial property sector and some of the subsectors e.g. storage, which has a baby boomer driver and attractive yields.
Retail shopping centres are more difficult to understand. The advent of Amazon and the move to increased online shopping has seen price declines for retail shopping centres in the USA. In sympathy, some of Australia’s leading retail shopping centres such as Scentre (formally Westfield Australia Trust) and Westfield Group (now primarily international premium shopping centres) have fallen to the point where several analysts have buys on those stocks. The view that LPT property managers’ ability to adapt to Amazon is under estimated was put forward by Julia Forrest and Peter Davdison, portfolio managers behind BT investment managers listed property strategy. When Myer declined to renew its lease at Westfield Hurstville Scentre Group shopping centre in New South Wales, a chill went through the property trust sector. “They needn’t have worried”, says Julia Forrest, “That space that was doing $30M is now doing $100M”. “It’s a buzzing centre, it was an amazing opportunity to transform what was an old, tired centre into a food hub with lots of services, some mini-majors, that has just driven traffic through the roof”. As many a 19 of Myers 63 stores could close or shrink, the department store has flagged. “I’m sure they’re looking at other spots where maybe Myer won’t renew and are thinking the same thoughts”. In the Australian Financial review article on 13 November 2017, Forrest and Davidson quoted that while they do not take the seriousness of the Amazon threat lightly, they argue the property sector has not got enough credit for how it is responding. With Westfield, Davidson and Forrest comment “most people accept that there’s a great NAV or asset value uplift coming there through the development such as Croyden Milan and most recently Century City”. The US mall experience is useful in approximating Amazon’s impact but it is flawed too. American malls do not have supermarkets as anchor tenants because grocers, as they are known, are located on “strip” shops. The generation of foot traffic going to supermarkets – if you’re doing two visits a week, you’re generating a massive amount of foot traffic that you don’t see in the US. “Yes Amazon is a concern but I don’t think its terminal. If you assume that Amazon got 3% of Australian retail sales in the next few years, that’s roughly equivalent to $9B, which equates to the sales of Big W”.
The other factor that Burrells note is that the leases in major shopping centres are comparatively longer term and so any impact on the trade of individual retail stores is rather muted and delayed in terms of its flow through to returns to the shopping centre owners.
To summarise, the LPT sector moved from under-priced in 2009 to modestly over-priced in 2016/17, which was reflected in the yield on the property trust index falling below 4%. At 4.06%, Burrells remain unconvinced that index buying is appropriate and are more likely sellers of the index. Property yields are unfranked and specific stock selections with yields in 5-7% are more attractive. Caution in respect of the office sector is recommended, whilst the retail sector may well have over reacted to the threat from Amazon. Industrial property yields are attractive, including the storage subsector. Burrells also see the management of companies such as Lend Lease, Stockland and Mirvac as cleverly targeting property sectors and niches where those staple securities have made good profits, such as the RNA centre redevelopment in Brisbane and the Teneriffe/New Farm unit sector for baby boomers seeking to downsize.
The October blog was largely devoted to this topic as an update to the July blog. Those recommended portfolio settings remain intact. The tick up in long bond rates is consistent with a view of fixed interest which looks for shorter term and floating rate fixed interest securities. It has become clear that the international long term fixed interest rates are likely to rise before Australian rates, but it must be remembered that overseas interest rates have fallen to much lower levels than Australian rates and so there is more scope for a return towards rates that give central banks overseas some fire power. The logic that recovering longer term rates means property and infrastructure are trading above sustainable value remains intact and investments should be selective in these sectors. The US market remains on average at high valuations, but to date has not corrected given the carrot of lower US corporate tax rates. It may be a course of “buy the rumour, sell the fact”. The probability of a successful corporate tax bill in the US has increased over the past month.
Australian equities remain the sweet spot with the ASX S&P 200 index achieving the 6000 level in the past fortnight. This vindicates our overweight call on Australian equities.
Selective selling of stocks trading at unsustainable PEs and the purchase of good companies at reasonable valuations, adjusted for growth has seen a good opening period for the 2017/18 financial year.
Banks continue to face difficult political pressures, but reporting was generally good. Westpac and CBA were the stand outs on the reporting season, with concern around the NAB resizing initiatives. Both Westpac and NAB held their November dividends and the market has responded accordingly.
Resources have continued a strong march reflecting commodities prices and the energy sector is reflecting the higher oil price. Woodside has shown strong gains. Santos have turned the corner with valuations continuing to be above market price and an opportunistic bid.
In terms of Xfactors, the probability of conflict on the North Korean peninsula has diminished and this has allowed Asian stock markets to show good gains in the past month.
The markets have so far shrugged off political issues including citizenship turmoil in Canberra, the thankfully short election period for the Queensland State Election and the Mueller investigation in the US.
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