less is more for lpts...

Source: www.businessspectator.com.au

Less is more for LPTs
Stephen Bartholomeusz | 6:01 PM, 14 Jul 2008

GPT’s security price remains in freefall after last week’s shock downgrading of its earnings outlook. It isn’t, however, alone. It would appear GPT’s decision to clear its decks and slash distributions has provoked another reappraisal of the listed property trust sector.

Almost all the listed trusts have seen their security prices tumble further since the GPT announcement as investors have started to question the sustainability of the stapled trust model more aggressively.

GPT’s woes stem from its departure from its old pure trust model three years ago when it internalised its management. Seeking to boost distributions by exposing itself to more risk in expectation of higher rewards, it entered a European property joint venture with Babcock & Brown and created property funds management and development businesses.

While its approach to boosting distributions – largely the joint venture – was controversial, it was simply trying to emulate and compete for market attention with its stapled trust peers, all of whom had previously moved from the pure trust model to take on activities with operational risk.

The old trust model enabled the trusts to distribute all their earnings before tax and depreciation, borrowing or issuing equity to fund whatever capital expenditures they faced. When the sector shifted into its modern stapled security form – bolting a corporate entity to a trust – it maintained that approach in order to maximise distributions for yield-driven investors.

Yet property development and property funds management are qualitatively different – more volatile – with lesser-quality earnings than the passive rental income flows the trusts had previously generated.

For some trusts with development businesses and perhaps land banks – where interest has been capitalised until the development was completed and sold – underlying earnings have been over-stated. Funds management businesses, because of their reliance on the ability to originate transactions, are inherently vulnerable to a change in market conditions.

A reliance on increased borrowings and/or fresh equity to fund the gap between underlying earnings and distributions worked during the long sectoral upswing, which was characterised by very cheap debt and rising property values. It stopped working the moment the fallout from the sub-prime crisis swamped debt and equity markets, as well as Centro.

Merrill Lynch analyst John Kim advocated a shift to the US real estate investment model in an interview with Business Spectator’s Isabelle Oderberg on July 10. In the US, distributions are paid after the funding of capital expenditures. Goldman Sachs’ property analysts, starting from the same premise, are arguing the case for a shift in focus when valuing the trusts from yield to multiples of cash flows.

However they are valued in future, the sector first has to get through the transition from where it is today to where it needs to be.

GPT took what appears to be a worst-case approach to non-core operations in its guidance, factoring in a loss of transaction fees, development profits and returns on recycled capital – saying that development profits would no longer be included in its distributions. It has paid a brutal price for doing so, losing roughly $2 billion of market value in a single week.

In an environment where there is no certainty that the trusts will be able to raise new debt on acceptable terms, and where equity raisings would be seen as a sign of desperation if they could be made, conservatism might be punished but the alternative might produce something even worse.

Given the level to which the trusts as a sector – and its investors -- have become reliant on corporate earnings to boost distributions and yields, the re-basing of expectations and value itself is only a first step.

GPT and its peers will have to articulate a new and less sexy model for listed property trust ownership and then convince investors that it is both attractive and sustainable. Given the external environment, there is likely to be continuing volatility and pain for the sector until it is remade.


Ends.

Cheers, Pie :)