Ann: June 2022 Valuation Update and June Quarter Distribution, page-2

....Yes the cap rate compresses 3pbs even though the 10yr has exploded 250bps the other way!

The downside scenario here isn't even close to priced in and those that think otherwise only have to look at the end of the last credit cycle. Check out the 15 year share price charts for Goodman Group, Charter Hall, Mirvac, Dexus, Abacus, GPT, Growthpoint.

NONE have share prices higher than they were in 2007 and that's with companies like Goodman & Charter Hall being hugely successful and having much larger market capitalisations than in 2007.

How can these companies not be trading about 2007 highs?

Debt and then subsequent equity raisings at huge discounts right at the bottom.

I bet you’re now thinking, REITS are geared much lower than back in 2008. Pundits parrot this, however do the research yourself and check out the gearing ratios, we're talking 35-50% look through gearing back in 2007. Similar to nowadays but importantly and remember this for later, cap rates back then were 6%+ and today they are in the 4%’s.

So what happened in 2008?

As cap rates went up and rents stalled, property values started going backwards and the world went risk off. Banks became more risk averse, wanted lower leverage and charged higher interest margins. Most REIT's weren't getting close to breaching existing LVR covenants but as re-financing rolled around, banks wanted lower LVR's because property values were falling. So there was a double whammy of falling values and the need to have lower LVR's, meaning equity needed to be raised right at the worst moment. This was happening to every asset class at the same time and equity was getting sucked up in capital raises across the world to reduce leverage. So equity had to be raised at insane discounts to NTA. We're talking 90% discounts to NTA. Share counts literally tripled and quadrupled between 2007 and 2010 for a lot of these REITs, all at huge discounts. (Ie. Abacus was only geared to 37% and quadrupled share count with a couple equity raises in 2009) The worst part is retail largely missed out on these distressed equity raises because they were mostly institutional placements. It won't be different if it happens this time.

Financial markets work very well when things are slowly grinding upwards, but when the cycle turns, it unwinds quick and it's already beginning. Banks are wanting borrowers to lock in a larger % of debt at fixed rates, they're also charging higher margins and this all means much higher all in costs of debt. 9 months ago, your all in cost of debt from a bank was in the mid 2% and now it's mid 4% when you account for interest rate swaps and higher margins. This means insto's can no longer buy an industrial property at a 4% cap rate because their interest rate coverage doesn't work, their distributions don’t work and so now they need to be buying at 5% or 5.5%, a 30% drop in values from the 4% cap rate. Then as property values start falling, banks get even more nervous and increase margins and want less leverage.....the story plays itself over again.

How bad could it get?

It could get real ugly especially when you consider the maths implications of such low cap rates against interest rates that are going ballistic.

CLW's portfolio weighted cap rate is 4.4%. The 10yr treasury is the same level now as it was in 2012, and back then the average cap rate of industrial property in Sydney was 9%.

If cap rates revert back to 9%, then the value of CLW's portfolio will halve and the value of your equity will go down 80%, however it’s even worse because on the way down and right at the bottom, they'll do a few cap raises and you'll get diluted to buggery and not participate in the upside to the same extent that you got a share of the downside. The share count of CLW will quadruple.

Do not average down into REITS. Commercial debt that needs to be re-financed every 3 years and has covenants is not the same as 30yr mortgages provided by a bank, that just require you to make your repayments.

For those of you who have too much in these REITS, lighten up. This is not the environment to be buying the dip, the upside is just way too small.

Most think this can’t happen again and the GFC was a once off. This happens to the REIT sector every ~15years…think early 1990’s.

As a final thought, the above is not destined to happen but in any event, be aware things can get much much worse and the upside at current prices is not that great, so be sensible with your averaging down strategy if you plan to go big.