Survival of the fittest

IFA Cover Story

By Wouter Klijn
Mon, 11 May 2009

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This year is unlikely to be one to celebrate for the real estate investment trust (REIT) sector, with the strongest REITs expected to survive, while the weaker vehicles fall by the wayside. However, opportunities exist amid the gloom. Wouter Klijn reports.

Darwin acquainted the general public with the concept of survival of the fittest, but he only started using the phrase from the fifth edition of his magnum opus, On the Origin of Species, onwards as a synonym for his theory of natural selection.

It was, in fact, English philosopher Herbert Spencer who coined the phrase around 1852 - shortly after Darwin's book had been published. Spencer, who was heavily influenced by Darwin's ideas, used the theory of differentiation in plants and animals to apply it to the business world.

He viewed the economy as a social organism evolving as business expanded to become more differentiated, with companies opening new branches and creating new products.

But he did not necessarily believe this evolution led to the best outcome. He was of the opinion that the nature of an economy would inevitably lead to unscrupulous practices and disarray. "It is a startling assertion, but it is nonetheless a true one, that those who resist these corruptions, often do it at the risk of bankruptcy," he wrote in 1865.

To call the practices adopted by REITs unscrupulous is rather harsh, but there has certainly been a degree of over-engineering of business models and financial products, which has contributed to the current state of the sector.

Many of the problems REITs face today find their origin in the evolution away from rent collectors to far more complex business structures that included funds management and property development operations.

The listed property trust industry became a scale-play, chasing transactions at silly prices to boost funds under management, and so their fee income. They took on more debt to fund their expansion plans and sometimes even to pay distributions to shareholders.

But when the financial crisis hit, the ability to get new loans and roll over existing ones at maturity became suddenly problematic. As capital dried up, the stock prices of REITs went down, and have now arrived at a point where many prices reflect investors' expectations the trusts will go bankrupt.

The current state of the industry shows remarkable similarities with Spencer's view on an economy: one of chaos, in which only the strong will survive.

Gearing
The decline of REIT share prices is largely linked to the level of debt they had assumed in the years before the financial crisis. And as capital started to dry up, investors' concerns about their ability to roll over debt maturities started to mount.

But the question many industry players are asking is whether investors' concerns over gearing - the amount of debt assumed compared to the value of the assets in the portfolio - have not taken disproportionate forms.

To a degree, it is a matter of perception.

In the Netherlands, it is not unusual to borrow 10 per cent to 15 per cent more than the value of a property when entering into a home loan. The Dutch not only borrow the complete sum of the house they have set their sight on, they also borrow money for the local equivalent of stamp duty, notary costs, and any renovations they might deem necessary.

When the financial markets regulator there carefully suggested in April this year that banks perhaps should not lend customers more than the value of the property, mass hysteria could only just be avoided. The first home owners' market would collapse, property lobby groups cried out, while politicians openly questioned the motives of the regulator.

In Australia, banks in general, and more so recently, will not lend you more than 90 per cent of the value of the house, and will certainly not consider financing purchasing costs. Still, when buying a property a gearing level of 90 per cent is not considered out of the ordinary.

Survival of the fittest

IFA Cover Story

By Wouter Klijn

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Unless you are a listed property fund, that is.

At the end of 2008, the average gearing level of Australian REITs stood at 44.4 per cent - the highest it has ever been, according to research by BDO Kendalls. Most trusts have enough money to cover their debt obligations. In fact, the average income derived from rent is enough to cover debt obligations three times, AMP Brookfield Redding executive director and global portfolio manager Kim Redding said at an AMP function in March.

Despite the outrage of many investors, gearing is not the problem, Redding argued, it is the way the value of trusts' underlying assets are calculated that has caused the despair in the sector.

"What happened in Australia is that the net asset value (NAV) approach was the primary measure that people would use," he said.

"I would suggest that in the very best instance a NAV analysis is an artwork, because we have no transactions taking place. You don't know what the appropriate capitalisation rate is."

Many industry participants agree it is difficult to estimate value at a time when very few transactions take place, because there is simply no comparison to make. Redding, therefore, believes NAV is the wrong way of looking at a trust's value. He believes the only way to make an adequate valuation is by looking at the cash flow generated by a company.

"There are companies in the listed property trust market that trade below 20 cents a share and have extreme discounts to NAV. The market is really saying: 'we're not sure if you're going to survive'," he said.

"But if you look at their cash-flow coverage to their debt service coverage, they still have plenty of cash available to service their debt. Nothing has really changed today from two years ago other than the artwork of trying to determine what their NAV is.

"Unfortunately, I think the focus is on the wrong metric here in Australia.

"It should be on: what is the cash flow coming from these companies, is it growing, is it stable, can you service your obligations, both interests and dividends, to shareholders?"

Planner input
Perceptions do not only come into play when looking at the value of a REIT, but also when looking at the very nature of the investment vehicle. In the past 15 years, REITs have shown extraordinary growth, often driven by the diversification of activities and aggressive acquisition strategies.

Not only did investors receive a steady income stream, the appreciation in value of these vehicles created attractive returns. Slowly but surely, investors were allocating money to REITs as if they were growth assets. They turned a blind eye to the limited liquidity of the underlying portfolio and to the more volatile performance of the peripheral activities, such as the funds management operations.

Financial planners are partly to blame for creating this perception of REITs, Orbis Australia fund manager Simon Marais says. "The people that invested in it didn't really understand what they invested in and now they are trying to get out," Marais says.

But he also argues it is easy to see how planners got trapped in recommending these trusts to clients. "If you look over the last 15 years, a fund has grown by let's say 5 per cent and yields by 7 per cent, so they said: 'I think it's a great investment'," he says.

"After 15 years [of growth], they were confident it was."

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By Wouter Klijn

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But property trusts were never intended to be growth products and when the market collapsed, investors panicked, causing a flood of redemptions. "The assets grew faster than they should have, and now people ask: 'what can we do?'," Marais says.

"The best thing is to hang in there."

Real Estate Capital Partners (RECAP) head of retail sales and distribution Michael Jaeger agrees financial planners have not always explained the nature of investing in property funds adequately. As a result, they were having difficulties in explaining to investors what has happened during the crisis.

"I don't know whether advisers were able to respond appropriately. [But] this is not a criticism; you couldn't have anticipated what happened," Jaeger says.

He says many people in the industry, not just planners, were led by the misconception that property always goes up. "People can't get their head around the destruction of equity [when property prices started to fall] and asked: 'where did the money go?'"

But when you borrow more and more money against over-inflated assets, there needs to be a correction at some stage and all you are left with is debt, he says.

He says he doesn't believe this will have turned investors away from REITs forever, although there may be some who will not return. "Self-directed investors, people who invest through CommSec for example, we might lose them," he says.

Australian Unity Investments head of property Martin Hession disagrees with the notion that financial planners have contributed to a distorted perception of what REITs are. "What really caused the redemptions is the government guarantee [on bank deposits]. I don't think the planners caused the problem; the government caused the problem," Hession says.

AUI has had to limit redemptions on all of its property funds, except its Property Income Fund. Hession says he hopes the government will withdraw the guarantee as soon as possible, so investors will start putting money in funds again.

"The Australian property market is still a very attractive market and you see overseas buyers starting to have a look," he says.

Interest has come, especially from Asia, while German property funds have also been known to snoop around.

The correct perception
False perceptions or not, REITs will have to address the concerns of investors about gearing levels for them to attract money back into their funds, and this is exactly what they have done in recent months. Since October 2008, REITs have raised over $8 billion in capital, and there will be more to come, according to Philadelphia-based ING Clarion Real Estate Securities director and portfolio manager Chris Reich.

It is likely Australian REITs will engage in a second round of capital raisings, Reich said during a recent visit to Sydney. The ongoing decline of NAVs and the Australian dollar means they need more capital to keep gearing levels down.

"In Australia, equity raisings were just enough to get them through 2009 and maybe a little bit of 2010. In most cases, it turned out to be not enough. That's why we expect a round two in Australia," Reich says.

REITs in the United States have gone much further in restructuring their balance sheets, he says, and that is why the market has done better there. In addition to capital raisings, they have sold off part of their assets, he said. "Some of the [US] companies have effectively covered their debt maturities all the way through 2011 and 2012," he says.

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Further capital raisings in Australia will put more pressure on the industry. It will have a negative effect on share prices as dedicated property investors will need to sell part of their holdings to participate in new raisings, he says. "Because the Australian market is not as deep as the US market, you will find that as one company raises equity nearly every other company needs to be sold to help fund that deal," he says.

As a result, ING Clarion has a rather grim outlook on the Australian REIT sector. "We are not as attracted to Australia as to other regions, because of the fact that they will have to go through a second round of equity raisings," Reich says.

But Australian REITs are not the only trusts struggling. The outlook for the entire global industry is far from rosy, Reich says. "We expect a further deterioration of fundamentals; rents will go down and vacancy rates will go up," he says.

Opportunities
Despite the gloomy outlook for the near future, the market has already priced in more bad news, and not only that, it has gone too far in its devaluation of the REIT sector, Reich argues.

"The market has overshot on the down side," he says.

Globally, REITs are undervalued by 20 per cent, he estimates, while in Australia the sector trades at a 27 per cent discount.

Much of this has to do with the expectations that some REITs will have to file for bankruptcy. Although there is a real risk banks will not extent loans to trusts, it is more likely that banks will just ask the trusts to pay a higher interest rate on their loans. Most REITs will survive the current capital drought, Reich predicts.

Therefore, for those with a long-term investment perspective, the REIT sector offers some great opportunities, fund managers say. "It's extraordinary how low things have gone down," Marais says.

As an example he uses the share price development of the ING Industrial Fund. "In 2007, it beat the $2.80, [but] now it's around $0.10-0.15," he says.

"[But] it's a good fund. It's not over-geared, and it's not going bankrupt. And there are heaps of them like that."

In many cases, the market capitalisation of the fund is below the combined value of the properties in the portfolio, but the problem for these funds is that they cannot just close down and sell the assets as there are very few buyers around.

Marais has traditionally allocated few funds to REITs, but in recent months he has increased his exposure substantially. "We probably are looking to get it up to 25 per cent. It used to be nothing, maybe 2 or 3 per cent, because it was very difficult to find value. Now, there is extraordinarily value," he says.

When asked whether a quarter of the portfolio invested in REITs would not narrow the focus of the fund too much and expose it to a substantial risk, he waves away the concerns.

"Look, there has been a huge change in price. The underlying business model [of these funds] hasn't changed. Yes, it's going through a classic cycle, but once the cycle has changed, these things will go up. People still need property," he says.

"I don't think anybody believes the Australian economy is going to be poor forever. We are having a cycle; it might be a big cycle, but a cycle nevertheless. In a few years everybody will say: 'Geez, these things were cheap; it must have been blatantly obvious.' But at this time nobody is interested."

Survival of the fittest

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By Wouter Klijn

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Last year, he started spending big on REITs, pumping almost $50 million into property stocks with the intention to hold them for at least five years. Some of the stocks that have lost 80 per cent to 90 per cent in value do not deserve the hammering they have received, he says.

"You need to work out what things are worth, because the price is going to fluctuate around. We have really gone for the small caps now, because they are really cheap," he says.

Survival
There will certainly be casualties in the sector, and some of the smaller and more highly-geared companies will disappear, either through delisting, liquidation or takeovers. But those firms that survive the turmoil and have some capital left will be able to profit from the opportunities that arise, as assets will come on the market cheaply.

"The higher-quality REITs, as we get through this recapitalisation period, will come out of this being stronger, and they will be able to take advantage of opportunities that will present themselves in the coming months and years," Reich says.

"Some of this will be through mergers and acquisitions. Now, we do acknowledge that this won't happen any time soon; M&A is on pause. But at some point those higher-quality companies will find it too enticing to pass on these opportunities.

"REITs in the next few years will be some of the most active buyers of real estate and we think that they will be able to do so at pretty compelling prices that offer attractive long-term returns."

In Australia, Reich believes Westfield is one of the better-positioned REITs to capitalise on a recovery. "Westfield's $2.9 billion raised earlier this year was more to help support its pipeline than to raise dry powder. I do think it is a company that is clearly going to be a survivor, and it will be able to take advantage of some of these opportunities," he says.

But the sector will have to do some significant soul-searching, market participants agree. Those that will survive are likely to re-evaluate their business model and go back to basics. The levels of debt will come down permanently and REITs will shed their peripheral activities to become pure income players again. It will be a period of devolution, but at the same time a return to quality and transparency.

"Especially in fund vehicles, where the emphasis was on growing funds under management without full regard to debt levels and quality of assets, there was just a frenzy," Jaeger says.

"In that environment you get people outbidding each other simply because they want to acquire assets to bulk up their funds under management, because in a lot of these structures your fee is based on your gross assets. Add to that the need to move into markets outside of Australia, where currency issues come into play, and the whole engineering issue became more complicated.

"There will be a return to simplicity, where investors need to be able to say: 'that's the building, that's the tenant, that's the amount of debt, that's the rent and that is the distribution that I am likely to receive'."