The valuations are first based off purchase price and then periodic "independent valuations" that only change when other similar property transacts (even then this process is often flawed, the valuer is picked and paid by the fund manager).

However, everyone (obviously including valuers) knows commercial property valuations (thus NTA) is adversely affected by risk-free rates going up massively, sticky inflation, a massive overhang of commercial property below A Grade that has permanently less demand (given retrofit feasibility/costs), office rents being driven lower, etc, etc.

Latest article: https://www.copyright link/chanticleer/property-is-sleepwalking-towards-its-biggest-test-since-the-gfc-20230319-p5ctch

Property is ‘sleepwalking’ towards its biggest test since the GFC

Interest rates have soared, but commercial property values have barely moved. Investors want little to do with a sector heading for a big dose of reality.

As one of the country’s top fund managers reminded Chanticleer recently, monitoring the actions of a company’s executives and directors is a tried and tested investment strategy.

When an insider buys, you buy. When they sell, you sell. And when they walk away, you always ask why.

Our fund manager and his team have spent months hunting for value in Australia’s ASX-listed real estate investment trusts, attracted by a group of stocks that are trading at discounts of up to 40 per cent to the value of the assets on their book, which in the property sector is called a REIT’s net tangible assets.

But in the end, he says he just needed to follow the insiders.

The chief executives of four of the country’s seven largest REITs have either recently departed, or announced plans to. Scentre Group chief executive Peter Allen retired on September 30 last year; Vicinity Centres boss Grant Kelley left last November; Mirvac’s Susan Lloyd-Hurwitz signed off last month and GPT’s Bob Johnson announced last month he will retire by the end of this year.

While the retirement of four long-standing executives is not necessarily a surprise, the fund manager says it’s become clear the quartet got out at the top of the cycle.

Suddenly, the five key drivers of the commercial property market – occupancy, rents, valuations, incentives, and cost of debt – are all moving against the sector at the same time.

He believes the commercial property sector is sleepwalking towards a painful period that is likely to involve plunging asset values, distressed property sales and potentially even capital raisings.

A veteran banker to the sector is similarly bearish. “These guys have had a tailwind from falling interest rates and rising valuations for 20 years. This will be their biggest test since the GFC.” It seems like every day brings a weird and wonderful story from the world of commercial real estate. In Europe, private capital giant Blackstone defaults on a bond backed by Finnish offices and retail outlets. In America, investors from the Pacific Investment Management Co. to the Columbia Property Trust default on bonds, while property developer RXR had handed back the keys to some of its Manhattan office buildings.

But in Australian commercial property, it’s what is not happening that is most remarkable.

Where North American commercial property values fell by the second most on record in the December quarter, and European valuations are recording similar falls, the February reporting season delivered a baffling lack of movement.

Morgan Stanley analyst Simon Chan says capitalisation rates (basically the property version of yields, which move in the opposite direction to valuations) moved just 0.11 per cent in the December half, to around 5 per cent, despite Australia’s 10-year bond rate surging from 1.4 per cent to 3.6 per cent over the course of last year.

Just as remarkably, Chan says NTAs fell just 0.6 per cent in the December half.

This would appear to be fantasy land stuff, given the movements in listed property valuations and in overseas markets. But the methodology by which independent valuations of properties are conducted allows REITS to look investors in the eye and stand by their NTAs.

Property valuers rely heavily on comparable transactions to judge what a building is worth. But because of the gap between what buyers think their property is worth and what sellers are prepared to pay, properties are being pulled from sale before the owner has to swallow a much reduced price; The Australian Financial Review’s property editor Nick Lenaghan revealed on Saturday how super fund giant REST had yanked a Melbourne office building from sale after receiving bids about 15 per cent below book value.

Chan says transaction values across the industrial, office and retail sectors came to about $300 billion in 2022, which was a third lower than in 2021 and between 20 per cent and 25 per cent lower than in pre-COVID times. Fewer transactions might protect valuations for now, but they also mean the risk of a disconnect from market realities is growing.

So what are the REITS playing at?

“The minimal moves in asset values and cap rates can only mean two things in our view,” Chan says. “The revaluations in the [REIT’s] August 2023 results will be more material and the listed asset owners have simply delayed the inevitable, and/or the REITs are gripping onto their current book values and metrics, hoping that they can grind out the next 12 months to 18 months, with pressure alleviated when interest rates start to decline in 2024.” Material revaluations may only be months away

Chan says diplomatically that the lack of movement in valuations “could indicate the traditional REIT valuation metric of price-to-NTA is less dependable”.

Given the steep discounts to NTA that REITS are trading at, the market seems to share the less polite view of our fund manager: NTAs are fiction right now.

To be fair, bond markets are suggesting that rates will eventually come down, possibly as early as the later stages of calendar 2023. But those cuts are likely to come well after the sector’s next balance date of June 30. Material revaluations may only be months away.

If valuations were to fall between the 15 per cent implied by the REST example, and the 20 per cent drop that will occur if cap rates rose from 5 per cent to 6 per cent – as observers such as Shane Quinn, chief executive of boutique fund manager Quintessential Equity, believe is likely in the office market – then pressure could build on REITs which are testing the top end of their target gearing ranges.

Macquarie analysis shows that since the GFC, gearing levels across the REIT sector have remained stable at between 25 per cent and 35 per cent. But the amount of gross debt has risen from about $200 billion to around $375 billion over that period, and if valuations start falling, the divergence between debt and gearing could start to close again.

REITs have a few options to reduce debt. They can hit pause on developments, something several, including Mirvac, announced they would do last month. They can sell assets into a market that may show distress. Or they can raise capital.

Our banker says selling a property at a 15 per cent discount will be more palatable than the incredibly dilutive capital raisings that the sector was forced to undertake during the GFC. Those raisings still haunt the sector – even sector leader Goodman Group, which has ridden a logistics property boom to deliver a decade of strong share price growth, still trades below its 2007 share price highs.

Industry leaders are pinning their hopes on strong rental growth offsetting any rise in cap rates. At an event hosted by Citi earlier this month, Charter Hall chief executive David Harrison, pointed to strong occupancy levels and the 3.6 per cent rental growth the group gets on its office properties “every frigging year” as evidence of the attractiveness of the Australian commercial property sector.

“There is no doubt Australia has always had, and is continuing to get, the most attractive rental annual bumps in the world.” He and Dexus chief executive Darren Steinberg agreed there was pain coming for parts of the market, but expect bifurcation between newer, greener and more modern stock and older properties. This is particularly the case in the office market; Harrison says those with second tier stock could be “looking at US-style 20 per cent vacancies”.

Unsurprisingly, every REIT chief executive seems to believe they are on the right side of this bifurcation. And none countenance a fall in second tier rents and values depressing the top tier too.

There is also a question as to whether rental growth will be as strong if the predicted economic slowdown arrives. Rental collection was strong in the December half across the sector, but what that looks like a year from now is a fascinating question.

It’s important to note that different parts of the commercial property sector are likely to experience different rates of change in the next 12 months.

The office market, still adjusting to remote work and oversupply in key markets such as Melbourne, is generally seen as most vulnerable.

Retail has held up well, but faces a test as consumer spending slows.

Industrial (particularly logistics) has enjoyed a strong few years and should benefit from the realignment of supply chains, but valuations are high and there are signs overseas logistics markets are slowing as ecommerce normalises after the pandemic.

Right now, investors don’t seem to be discriminating too much between commercial property’s sub sectors. They’re just waiting for the industry to get its big dose of reality.