3 REITs to watch out for

Roger Montgomery

Montgomery Investment Management

A REIT, or Real Estate Investment Trust, is an entity that owns income-producing real estate. Think of a managed fund that concentrates on property rather than stocks and you have the idea for a REIT. REITs offer investors a partial interest in the rental income, capital appreciation and/or development profits of a variety of property classes from residential to industrial. 

Property categories include Commercial, which encompasses the Leisure, Retail, Office, Healthcare, Industrial and Hotel subcategories, and overseas, Residential REITS also exist. And of course there is rural or farmland.  The big names in property REITs in Australia include: Lendlease, Mirvac, Stockland, Westfield, GPT, Scentre, Vicinity, Goodman Group and Dexus.

The obvious benefits of REITs include diversification through a low correlation with the broader market (although that might arguably be untrue most recently), income source diversification and stability and a possible hedge against inflation.  Listed REITs also offer the immediate benefit of liquidity of the fractional interest in the property.

But there are downsides. Management can and have travelled ‘off piste’ in the past, debt fuelling expansion aspirations ahead of the global financial crisis, bringing many REITs to their knees and requiring refinancing well below net tangible asset backing, which permanently destroyed value for incumbent unit holders.

Another downside more relevant to investors contemplating a holding in REITs today, is the end of a 35-year decline in global interest rates, which has been a tailwind for asset values globally.

Property investors must ignore all the talk about a shortage of land, net migration and Chinese demand.  And rural property investors should be cautious about talk of the rising Asian middle class and associated appetite for protein and westernization of taste buds. These same arguments were used to promote rural property in Omaha in the 1960s!  Property trust value drivers are typically CPI, Market Rent Reviews, Vacancies, Refurbishments and the difference between property yields and bond yields.

It is vital that investors understand the financially damaging implications of rising interest rates.  In July 2016, US 10yr Treasury bond rates fell to 1.36%, their lowest level since 1773 – when Captain Cook first crossed the Antarctic Circle.  Since then, rates have risen to 2.61% raising the cost of funds for banks, who must pass these costs onto borrowers.  At the same time, higher bond rates lead to increased discount rates (known as capitalization rates in property circles) – the rate used by professional investors to calculate the ‘present value’ of future rental streams from a property.  When discount rates rise, present values decline meaning the value of those future income streams in today’s dollars is less and so the property is ‘worth’ less. Indeed, it is quite possible the $4.7 billion of revaluations in the listed RIET sector for the six months to December 2016 represents a peak.

The change in direction for interest rates is occurring after three and a half decades of asset-inflating declining rates, which have conditioned investors into believing the mantra of many property bulls that rates will stay lower for longer and asset prices will remain elevated.  But speculative bubbles are appearing in everything from fine art and wine to collectible number plates and high prices along with record low yields will ensure investors lock in inadequate returns for many years if not a lifetime.

Irrespective of whether interest rates are rising or falling there are some basic economics that investors should be aware of.  The most attractive economics can be found where land comprises a high proportion of the total value of the property and the building comprises a smaller proportion.  While there are tax advantages related to depreciation of buildings, the long term economics of a high rise office tower – where land is small and the building large – are undesirable.  This is because buildings date.  When buildings date, and newer buildings compete for tenants, top tier tenants move.  Buildings move too, from A-Grade to B Grade and then C-Grade.  As they age, they become more expensive to upgrade and raise to a standard suitable for top-tier tenants.  Left to date for too long and land lords (that’s you if you are an owner of units in the REIT) may discover declining rents from second and third tier tenants and the demolition or replacement of a building too costly.

The Art Deco-inspired Empire State building stood as the world’s tallest building for nearly 40 years, from its opening by President Hoover in May 1931.  And while the building became famous two years later for being the scene of King Kong’s death, the building failed to generate a profit until 1950. In 1951 the Empire State Building was sold for a world record price of $51 million and it gradually began to date.  Between 1993 and 2011, 6500 windows were replaced, 20 miles of fibre optics and copper cabling was retrofitted and an energy efficiency retrofit program was completed.  The elevator system was modernized for the second time, the first being in in 1966 and in 2010, a $550 million renovation commenced, without which the building’s current popularity with tech companies would not exist.  Owning office buildings long term is an expensive exercise with much of the rental income required to be reinvested for maintenance and upgrades.  Any long run economic benefit comes from the land underneath.

For Australian residential investors, REITS have a role to play that is simultaneously educational and concerning; The absence of any residential listed REIT in Australia is evidence of an absence of sufficient income return.

Tenanted industrial property, on the other hand, enjoys much more attractive economics than both office and residential categories. Located on relatively larger sections of land, with little more than a steel shed sitting atop, owners benefit from much lower maintenance outgoings and relatively cheap replacement costs.

Three Property Trusts to watch or watch out for follow.

Bunning Warehouse Property Trust (ASX:BWP) (SELL)

The Bunnings Warehouse Property Trust owns 80 warehouses enjoying 99.9% occupancy.  Annual rents amount to $150 million and the weighted average lease expriy (WALE) is 5.5 years.  Importantly however the WALE has been declining from 5.9 years on 30 June 2016 and 6.4 years on 31 December 2015.  This is important because it is expected several shorter lease properties will be vacated as Bunnings moves to relocate to now vacated Masters locations.  More than 23 per cent of the portfolio expires over the next 3 years and while BWP management have outlined longer term alternative uses for various assets, the risks have increased.  Five properties have already been vacated representing nearly seven per cent of annual rent.  A further sixteen properties are expected to be vacated as Bunnings relocate to preferred locations left by Masters.   While capitalization rates on newer properties have compressed amid the continuing low interest rate environment, this will change, and combined with the shortening lease expiry profile, increases the risks.

GPT Group and Stockland (ASX: GPT, ASX: SGP) (SELL)

Retail sales have been grinding lower generally thanks to a weaker currency and tourism.  Low wages growth and already record high debt levels are offsetting any wealth effect from rising property prices.  Increased competition from international hard discounters in the fashion and super market sector are also pressuring margins.  Apparel makes up  almost 30 per cent of rents in regional malls and Australian retailers face an ongoing threat from the likes of Zara, Uniqlo, TopShop, H&M.  More importantly the size of these international operators allow them to negotiate lower rents that are generally around half those of local operators.

And all this is occurring before Amazon arrives in Australia to unleash its offer that overseas consumers have been enjoying for years.

Retail landlords and retailers themselves have described January and December in generally weak terms and further insolvencies, such as Marcs, Rhodes & Beckett, Pumpkin Patch, David Lawrence, Howard Storage, Payless Shoes, Herringbone are expected to weigh on sentiment, even though the gross lettable area of these operators is less than half a percent of their totals.  GPT noted “Retailer profitability will remain a headwind”.

Roger Montgomery
Founder and Chairman
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger has than three decades of experience in investing, financial markets and analysis. Roger also authored the best-selling investment book, Value.able.

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