Last year we divided the AREIT sector into two groups: fund manager AREITs and property owner AREITs. Fund manager AREITs grew exponentially over the previous couple of years, acquiring interests in funds management businesses and building massive development books for which the market paid higher and higher stock prices in anticipation of future growth potential. By comparison, the property owner AREITs continued their usual business of buying property and collecting rents, being marked down by the market for lack of growth potential.
Now the reverse is the case. Funds management and development businesses are deemed effectively worthless by the market and the focus is now firmly on underlying property portfolios, both for their operating profit and their asset value.
This is now reflected in the pricing of the AREIT sector, with a return to pricing by dividend yield and discount to NTA. Though interpreting NTA is challenging, it provides a range of opportunities to identify potentially mis-priced AREITs that may offer good value over the medium term.
What is NTA?
NTA is a useful comparative measure of the value of the underlying asset base of an AREIT after allowing for liabilities, expressed as a dollar amount per unit. NTA usually disregards intangible assets such as goodwill and represents the total value of assets, such as investment property, less the total amount of liabilities such as debt, divided by the number of units issued by the AREIT.
The critical variables in NTA are an assessment of the value of the investment property portfolio and a clear understanding of the debt structure. With most AREITs currently trading at a discount to NTA, the market is clearly sceptical about either the accuracy of stated NTAs, the current debt position of the AREIT, or both. But, as the market is prone to overshoot on both the upside and the downside, are some discounts to NTA currently indicating value opportunities?
State of play
As property values fall around the world, reflecting the global economic crisis and the limited availability of bank lending, all AREITs covered by Morningstar reported falls in asset values which range from 1.6% to 11.0% at December 2008, as shown in the table below. While the percentage falls are not the massive levels anticipated by the financial press, they still show some AREITs took a bigger hit than others.
Clues as to whether that hit was big enough can be found in the rise in weighted average capitalisation rates (WACR) shown in the table, which show weakening to be in a range from 32bps to 78bps. As a weighted average, this represents a composite of all the properties in an AREIT's portfolio in all property sectors and in all markets around the world. In broad terms, the market is expected secondary property to fall in value more than prime property, US and European property to fall in value more than Australian property and industrial property to fall in value more than retail and office property.
So the weakening in WACR was greatest for DXS, MOF, MCW, GMG and GPT. This reduces one aspect of risk in each of these AREITs and supports our BUY and ACCUMULATE recommendations, with the exception of MCW where our overriding concerns about debt refinancing support a HOLD recommendation.
At the other end of the spectrum, WACRs for IIF at 33bps and VPG at 38bps did not weaken as much as expected. Given their underlying portfolios of secondary quality property, industrial assets and offshore exposures, much greater levels of capitalisation rate weakening may have been expected. This suggests that current NTA may be too high with scope to fall significantly, potentially leading to further pressure on lending covenants and further supporting our AVOID recommendation on both stocks.
Of the remaining AREITs covered by Morningstar, CFX is notable for capitalisation rates only weakening by 32bps, leading to a fall in property values of only 1.6%. Though CFX has some super prime shopping centre assets in Melbourne's Chadstone, Sydney's Chatswood Chase and Brisbane's Queens Plaza, which may be expected to better hold their value, the balance of the portfolio is much less defensive and greater value falls may be expected in future periods. Reflecting this risk, we maintain our HOLD recommendation on CFX.
Code Company Name NTA $* WACR %* WACR Rise bps* Prop Val Fall %* Recommendation
WDC Westfield Group 12.63 6.18 41 6.8 Accum below $11.00
SGP Stockland 4.86 7.20 51 5.9 Buy below $3.50
GPT GPT Group 1.43 6.50 50 11.0 Buy below $0.60
MGR Mirvac Group 2.44 7.01 46 6.2 Accum below $1.25
CPA Commonwealth Property 1.32 7.00 50 5.3 Hold below $1.00
IOF ING Office Fund 1.30 6.80 50 6.6 Hold below $0.65
MCW Macquarie Countrywide 1.46 7.50 70 10.0 Hold
IIF ING Industrial Fund 1.66 7.30 33 5.1 Avoid
VPG Valad Property Group 0.51 8.00 38 4.8 Avoid
*At 31/12/09
Valuation policy
The level of change in value of an AREIT's portfolio is heavily influenced by the board's choice of valuation policy. Ideally, the board would have every asset revalued by an independent valuer every six months and so provide full transparency. Less transparency is provided by a board that maintains an archaic three-year rolling valuation programme, where each asset only gets independently valued once every three years. The least transparency is provided by a board that decides to undertake the valuations itself, without the use of an independent valuer.
In the last reporting season, none of the AREITs covered by Morningstar independently revalued every property at the balance date and all used some level of internal board valuation. Probably the best transparency is provided by WDC, who have every property independently revalued once a year and updated by a board valuation for the half year. This provides unitholders with a high level of confidence that the value of the property portfolio stated in the accounts has been determined at arm's length from the board by professional valuers who are qualified and skilled. Showing a disappointing lack of transparency, BWP continue to undertake independent valuations on a three-yearly cycle, with 13 properties independently valued at December 2008 and the balance subject to "directors' valuation using recognised valuation methodology" though subject to a methodology review by the independent valuer.
The balance of AREITs covered fell somewhere in between, with a mix of independent external and board internal valuations leading to differing degrees of transparency. Given the highly competitive fee environment in the valuation profession and the increased level of transparency provided to unitholders, it is staggering that some boards persist in undertaking internal valuations and incredible that their insurers are willing to continue to accept such an unnecessary liability.
Property valuations and debt
As property values fall, if an AREIT's debt remains constant then their gearing increases, with gearing being an expression of the level of asset values relative to the level of debt. As the table shows, at December 2008 gearing levels for those AREITs covered by Morningstar ranged from 31.9% to 60.8%, with half under 40%. While the absolute level of gearing is important, as asset values continue to fall the level of gearing relative to lending covenants has become a major issue.
Lenders generally have some form of constraint or covenant concerning the level of asset values relative to debt and the level of cash flow relative to interest costs, the second being the most important in a commercial sense of viability. At the moment, high occupancy levels in the underlying property portfolios mean that interest cover covenants are generally not a problem for most AREITs. If a covenant is breached, then lenders usually have the right to demand their money back. Unsurprisingly, AREITs have done all they can to avoid this, including highly dilutive equity raisings.
The table (below) examines gearing and covenant headroom for the major AREITs. Low gearing and comfortable headroom represent the lowest risk trusts, led by CFX. The next best-placed are trusts with low gearing but limited headroom as these should be able to renegotiate covenants if necessary and for a price. Those with high gearing and ample headroom may not be at risk of a breach but refinancing on debt maturity could be difficult. The worst-placed are IIF and MCW, which score badly on both measures.
Notably, not all covenants are calculated in the same manner and it is important to understand what factors impact each. For instance, gearing based on total liabilities is impacted by changes in the fair value of interest rate and currency hedges whereas those based solely on debt are not. Additionally, intangible assets are not usually included in gearing covenants but for GMG they are, so a writedown would push gearing higher.
Discount Distribution Bal Sheet Covenant
Code to NTA % Yield % Gearing % Limit %
GMG 67.6 44.1 41.2 60
GPT 70.3 16.9 33.7 40
MOF 73.8 23.0 43.5 60
Short-term outlook
In previous YMWs we focused on three AREITs that had over shot on the way down and were considered mis-priced as property owner AREITs. These were GMG, GPT and MOF. As the table shows, despite recent price rallies each continues to offer good value with a substantial discount to NTA.
Code Covenant Gearing Covenant Limit Head room Gearing Calculation
CFX 31.9% 50% 18.1% Total Liabilities / Total Tangible Assets
CPA 31.9% 40% 8.1% Total Liabilities / Total Assets
GPT 33.7% 40% 6.3% Debt / Total Tangible Assets
WDC 34.6% 65% 30.4% Net Debt / Net Assets
DXS 38.0% 55% 17.0% Debt / Total Tangible Assets
GMG 41.2% 60% 18.8% Net Debt / Net Assets
IOF 42.4% 50% 7.6% Total Liabilities / Total Assets
MOF 44.4% 60% 15.6% Total Liabilities / Total Assets
IIF 59.8% 60% 0.2% Total Liabilities / Total Assets
MCW 60.8% 70% 9.2% Total Liabilities / Total Assets
This is despite significant downward property valuation in December 2008, the prospect of strong distribution yields though with some risk of distributions being cut to preserve capital, and a reasonable margin between balance sheet gearing and covenant limits. We have BUY recommendations for each.
GMG Price at posting:
35.9¢ Sentiment: Hold Disclosure: Held
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