biggest risks?, page-8

For those interested - straight off Huntleys' Not that I put too much store in broker reports. I've learned the hard way to rely on ones own decisions as I can then only blame myself for the faux pas along the way. Nonetheless this only adds to my information base.

Prime Australian commercial properties are now selling at close to book values, increasing our confidence that prices have bottomed. Pressure on property prices eased following massive AREIT equity raisings, thawing debt markets and the relatively strong domestic economy. This prompts us to upgrade valuations on some AREITs who focus on property ownership. Valuations remain based on discounted cash flow analyses with upgrades predominately the result of lower discount rates. We suspect there is further downside to international property valuations and remain wary on this front. In this report we look at Commonwealth Property Office Fund (CPA), CFS Retail Property Trust (CFS), Dexus (DXS), ING Office Fund (IOF) and ING Industrial Fund (IIF). IOF benefits most from this review, with fair value rising 25%. Net Tangible Asset (NTA) backing proved a poor measure of intrinsic value over the past couple of years, illustrated by some big falls in the following table. Understanding its limitations is crucial in determining fair value of AREITs. Firstly, NTA is only as accurate as the underlying property values it’s based on. Secondly, it doesn’t capture other factors including financial/debt risk and fee liabilities associated with external management.

NTA Falls
Peak NTA Latest NTA % Change
CFX 2.32 2.02 -13%
CPA 1.62 1.15 -29%
DXS 1.90 1.01 -47%
IOF 1.81 0.80 -56%
IIF 2.35 0.67 -71%

The bigger falls were due to 1) higher gearing which magnifies movements of underlying property values on NTA, 2) exposure to international markets which experienced worse falls and 3) large dilutive equity raisings at big discounts to NTA, relating to the first two points. These issues have now largely run their course and further downside to NTA is limited. Conservative formal policy stipulating low gearing and a domestic focus saw CFX and CPA enter the financial crisis well placed, requiring minimal new equity. IOF and DXS had big equity raisings so are now conservatively geared. IIF remains highly geared even after a major dilutive issue and should only be considered by risk tolerant investors. All trusts mentioned now have wide covenant headroom. IIF’s limit will probably revert to historical levels of around 55% on future debt, providing slimmer headroom.

Gearing Comparison
Look-Through Gearing Covenant Gearing Covenant Limit
CFX 27% 32% 50%
CPA 24% 28% 45%
DXS 31% 32% 55%
IOF 26% 31% 50%
IIF 44% 48% 71%

Falls in unit prices ably predicted which stocks would suffer the greatest NTA falls but in most cases fell too far as the stock market crashed. Now unit prices are rising back towards NTA as risks recede and the market gains confidence in book values. Some AREITs still trade at substantial discounts due to perceived risk, presenting opportunities.

Valuation Comparison
FY11 Earnings Yield FY11 Dist Yield Price Disc to NTA
CFX 6.5% 6.4% 1.95 3%
CPA 7.3% 5.8% 0.92 20%
DXS 8.8% 6.3% 0.80 21%
IOF 9.3% 6.6% 0.59 26%
IIF 8.4% 6.4% 0.50 25%

Unsurprisingly, low risk domestic focused trusts CFX and CPA have the smallest discounts. CPA’s earnings yield is relatively low because most of its debt was recently refinanced at a substantially higher interest rate. DXS and IOF are arguably the best value in this group. They face moderately higher risk than CFX and CPA with international exposure and rising vacancies but compensate with attractive earnings yields and big discounts to NTA. IIF compares unfavourably being both higher risk and more expensive than DXS and IOF, demonstrated by substantially higher gearing, lower quality properties and a lower earnings yield. IIF is definitely not a preferred exposure to the sector. Future returns to AREIT investors are likely to be less than for equities, implying lower risk. While AREITs were one of the very worst performing sectors in the crash, they should be lower risk going forward as for the most part balance sheets are now healthy and property values more realistic. There is upside to earnings over the medium-term from strengthening economies leading to rental growth and thawing debt markets leading to cheaper debt via a reduction of interest margins. Base interest rates will rise as the cycle progresses, partly offsetting these gains. Earnings growth should lead to capital appreciation and so should increasing use of debt as market confidence returns.

IOF was similar to DXS in that it had too much gearing and international exposure but slim covenant headroom saw it punished to a much greater extent. IOF was hit hard by the tumbling A$ with its debt denominated in US$ and Euros. Currency exposure was reduced after raising equity, locking in massive losses before the A$ rebounded strongly. Terrible timing, terrible management from a supposedly sophisticated financial group! Balance sheet is now in good shape. The property portfolio fell 18% in value over FY09. Recent sale prices are reassuring but we remain cautious towards the European portfolio value. NTA is $0.80 or $0.78 after adjusting for external management. Performance fees are not a concern in the foreseeable future. Fair value rises 24% to $0.68, a 13% discount to reflect risks relating to international exposure and major near-term lease expiries. Distribution yield at fair value is 5.7% unfranked, based on a 70% payout ratio. Buy under $0.57.