Growth Point Properties Australia Strategic Viewpoint

Boy has this stock been nicely whacked over the last few years:


5yr share chart showing performance over the last five years, especially the coronavirus years with zero interest rates (which enabled the market to reprice upwards as rents where still flowing in, but interest costs become minimal in a zero interest rate world.

Now a 10 year chart showing performance over the last 10 years. The reality is that over the last 10 years, interest rates have been low and declining. A fanstasic time to hold REITS, UP TO early 2022.




Why only to up to early 2022?
Because the market suddenly realized that interest rates won't be zero forever.

And from this early 2022 point in time the share price has just gone south.

Why is this so important?
Because REITS are effectively a form of 'bond like returns'. Property income is generally is stable and with long leases the future revenue and revenue growth is quite easy to predict. Hence the term 'bond like returns'.

So why the 'blow up'.
In 3 simple words 'debt, interest expense and cap rate'.

Each of these 3 simple factors interplay to provide a 'fundamental value' for the REIT.

Firstly debt: In itself this is not much of a worry. UNTIL the market gets worried. When the market get's worried, debt levels come into play as effectively someone is lending the REIT money. When they lend money they will impose certain conditions, usually that debt is tied to both interest servicing cost (is the income sufficient to meet the servicing cost) and next is that debt safe: so they impose conditions around maximum debt against the value of the properties (think of it like the banks when you go for a housing loan: can you afford the repayments, and is the value of the property sufficient to cover the loan). So both these factors go into the debt contracts.

So for debt: the market gets jumpy for two reasons:
a) The debt level: if the property price drops, then then REIT won't be able to refinance as much (as the debt Covent will have a debt to property max value).
b) Debt servicing costs: if the interest rates expense on servicing the debt rise, then eventually the debt will be in breach where the interest expense rises above a certain level (eg rental income must be at least two times as much as interest expense.

Cap rate is very relevant: because the Cap rate is essentially the valuation tool to value the property.
In very basic English (its more complicated, but I am trying to keep this very simple) the CAP Rate is the net yield on the property. Again keeping this very simplistic, if a property was valued at $100 and had $5 of net income, then the cap rate is 5%.

But the market is to somehow come up with a fair valuation, they cannot look at the cap rate in isolution.

So the CAP rate has to be adjusted by the risk adjusted return. (All risky assets have to be adjusted by the risk adjusted return).

This makes sense, if one thinks about it. Does one want a risk free return, or a return with risk. Of course the risk free return. So then every other risky asset has a premium (more income or yield if you like) to compensate you for investing in that risky asset.

So then the CAP rate has to reflect this risk free return + a risk component to hold the property.

And here we are in a doozy of a problem.

When interest rates were zero, there was no risk free return. You put your money in a bank or term deposit, and basically you got ZERO interest income.

So going back to this statement: "So then the CAP rate has to reflect this risk free return + a risk component to hold the property."
If the risk free return is zero (because interest rates are zero), and property pays 5% net income:
Then the CAP rate is 5% (0+5=5).

But what about now?
Interest rates are not 0% anymore. If using the 10yr government bonds as the 'risk free rate of return', the 10yr government bonds are 4.8%odd.

Now go back to the original simplistic formula:
Risk free return + risk premium.

Now add the latest market numbers:
4.8% + 5% = 9.8%.

So now we understand why the market is having one serious spazy attack.

Whaaaat?
9.8% CAP rate!!!!
GOZ cap rate is only 5.6%

So what happens, for GOZ cap rate to go to 9.8%, how much do they need to write down the value of their properties????

Now I am very much simplifying things. Even in a zero interest rate world, to borrow it wasn't zero it was maybe 2%.

Also the 'risk premium' is not usually 5%, its usually around 3-4%.

But here is some reflectional thoughts to take away:


This graph shows you that back in FY13 the cap rate was around 8%, at the moment it's 5.6%

So that's quite a bit of negative retracement of current cap rates to their more historical norms.