fat prophets rjt analysis

Since our last review (FAT335 and FAT339) the Babcock & Brown (BJT) and Rubicon Japan Property Trusts’ (RJT) unit price performance has been disappointing, driven by a change of sentiment towards the sector. However, we believe the fundamental case for investment in Japan’s property sector remains as compelling as ever.

The sector’s current loss of investor enthusiasm is highlighted by the Tokyo Stock Exchange REIT index (real estate investment trust). As shown below, the index has corrected from the all time highs in recent months.

Nevertheless, given the rapid price appreciation evident from late 2006 through to the early part of this year, the index was undoubtedly due for a pull back. And with downward momentum slowing, a period of consolidation is likely before resumption of the upward trend.

In any event, we believe the sector’s recent performance does not reflect the underlying fundamentals. Indeed, Japanese land valuations are continuing to rise, gaining 20 percent over the year to 31 March 2007. And as the chart below shows, the recovery valuations following the early 1990’s economic stagnation has only just begun.

In addition, as Japan’s economy recovers, higher levels of business activity should increase demand for the country’s already tight supply of office space. Vacancy rates in central Tokyo are currently just 1.6%. We would expect this to support valuations and drive continued rental growth for Japan’s property trusts.

A further positive is the fact that institutional investors remain committed to the sector. For instance, Goldman Sachs recently purchased Japanese property manager, Simples Investment Advisors, for US $1.4billion. In addition, France’s second biggest bank, Societe Generale, plans to expand its Japanese property portfolio to US$1.5billion over the next three years.

And turning to the Trusts themselves, their operations performance certainly appears impressive. In the 12 months to 30 June 2007, BJT generate net operating earnings of $56.2 million, up 43 percent on last year. Although this was largely due to an expanded property portfolio, the Trust still achieved over 20% earnings growth on a per unit basis.

The result contributed to a 22% increase in the Trust’s distribution payments for the year, from 9.76 to 11.9 cents per unit. The distribution growth looks set to continue, with 2008 Bloomberg consensus estimates of more than 13 cents per unit, yielding around 8.6%.

In the 3 months to 30 September, the Trust has continues in the same acquisitive vein with a number of additions to the property portfolio.

As is typical for the sector, BJT’s balance sheet employs a large amounts of debt. As at 30 June 2007, the Trust’s net debt equity stood at 88%. Nevertheless, the Trust is well able to accommodate gearing around these levels, with operating cash flows covering the interest expense more than 5 times over.

Meanwhile, it’s a similarly story for the younger RJT, which has delivered an operational performance beyond prospectus forecasts since listing on the ASX last year. In the 8 months to 30 June 2007, the Trust generated net operating income of $16 million, up more than 60% on the initial forecast.

Meanwhile, the Trusts 5.5 cents per unit distribution delivered a healthy yield of more than 6.5% for the 8 month period. On a current year forecasts, the Trust on a yield in excess of 10%, 100% tax deferred.

And like BJT, the Trust’s strategy of growth through acquisition has continued in the first quarter through to September. The latest four additions are all retail properties at a total cost of $105 million, funded through debt.

The use of debt may be unnerving investors and perhaps accounts for RJT’s poor unit price performance this year. The recent debt funded acquisitions will have increased RJT’s gearing (net debt to equity) beyond the already substantial 128 % as of 30 June 2007. However, the Trust’s operating cash flows cover the interest expense by around 3 times and their secure nature provides additional comfort.

In other news, earlier this month Allco Finance Group moved to 100% ownership of Rubicon Holdings through the acquisition of the 79.6% it did not already own. Rubicon Holdings is the parent of Rubicon Asset Management, which in turns runs the Rubicon Japan Trust.

At the Trust level, management and ownership is unchanged and the deal therefore not particularly relevant. Indeed, with Gordon Fell remaining as Chairman of the real estate division we wouldn’t anticipate any change in strategy.

From a charting perspective, for RJT a downtrend has been in place since February resulting in a decline from a high of $1.135 to a recent low of $.80. With a base yet to establish, we cannot rule out the risk of further falls in the weeks ahead.

Similarly for BJT, following 10 months of decline since February, prices are currently testing a major support zone between $1.50 and $1.515. In our opinion, this region must remain intact if a deeper and more prolonged downtrend is to be avoided.

While we will closely monitor the price action around these support levels over the weeks ahead, it is important to note that both Trusts have implements buy backs. In addition to supporting the unit price, the buy backs indicate management’s belief in the sector’s long-term value and the Trust’s current undervaluation.

Overall, we believe investor sentiment will return over the longer term as the value of Japan’s property sector is recognised. In the meantime, the Trust’s strong operational performance and healthy distribution yield provide some offset to short-term unit price weakness.

Accordingly, Babcock & Brown Japan Trust and Rubicon Japan Trust will remain held in the Fat Prophets Portfolio.