30 April 2008
The listed property sector took a beating recently as it dropped more than 25 per cent in the wake of the credit crunch and the sub-prime crisis in the United States, wiping billions from market capitalisations.
In fact, the Listed Property Trust (LPT) sector dropped more than the equity market.
Property trusts with $128 billion in assets lost about 35 per cent in price compared to their 2007 highs, said the chairman of IBISWorld, Phil Ruthven.
Since 1988, BRW reports that non-residential property has jumped from $650 billion to just over $2 trillion dollars. Of this 21 per cent is in offices, 14 per cent is in retail and entertainment, 14 per cent in rural buildings, 11 per cent in warehouses, and 9 per cent in educational institutions.
Global investment in commercial property is predicted to fall 17 per cent to around US $770 billion dollars in 2008.
Where it all went wrong!
The availability of cheap credit meant Real Estate Investment Trusts (REITs) borrowed money to fund future growth. They also paid out a high proportion of earnings as dividends.
According to John White, the manager of Challenger's Property Securities Fund: "There were plenty of acquisitions at the end of last year despite the signs that the cost of debt was becoming prohibitive."
However, since December there has been a dearth of property transactions.
The onset of the credit crunch meant lower liquidity, which forced the hand of over-leveraged REITs. Investors then became extremely nervous as fear swept the market - the perfect recipe for a flight to safety.
To add to the woes, risk was mis-priced across all asset classes with property in the spotlight.
LPTs stood out - particularly if they were heavily geared.
The US market, gripped by the sub-prime mortgage crisis and ensuing credit crunch, was first to feel the pain.
The US Real Estate Investment Trusts (REITs) represent at least 50 per cent or more of the global asset allocation.
The exported crisis swept across the globe, infecting all property markets.
The UK was the first property market to feel the pinch with other markets following close by.
Europe, Britain, Asia and Australian LPT benchmark indices have all dropped, the most vulnerable LPTs were those with higher gearing.
UBS's global real estate strategist Kim Wright told the Australian Financial Review recently that listed property has suffered a more savage price-earnings ratio down rating than equities.
In fact, in Hong Kong and Singapore, REITs have been down-rated while the broader equity markets have gone the other way. But Hong Kong REITs still performed well against the global index, achieving 19 per cent returns.
Analysts from Goldman Sachs and JP Morgan predict that US property values will fall 20 to 25 per cent over the next two years, with UK commercial property to fall another 20 per cent, and European assets to fall around 10 per cent.
With falls also expected in Australia, the market has reflected that in share prices.
The Tsunami of sub-prime and credit crunch
Listed property vehicles with high debt and inadequate disclosure have been savaged.
One example is the over-leveraged Centro Properties Group, which went into kamikaze spin in December last year.
And more recently, Allco-managed Record Realty, with gearing of 85 per cent looks vulnerable.
John White said that Challenger was selling down its Centro holdings at the time of its collapse, and felt the company had bet against the capital markets and lost their shirts.
"This is the 'shake-out' we had to have."
He also feels that there was a lot of complacency in market from REIT managers, believing that low-cost debt and ever-rising property values were here to stay.
"But now debt is a dirty word and early indications are that property values are falling," he said.
The subsequent shakeout of the over-geared entities has prompted experts to ask if REITs are coming back to fair value.
White said that a combination of the reduced earnings outlook for many REIT stocks plus the uncertainty over real estate pricings, had led to the market taking a heavy hand to valuations - with some stocks sold down to 50 per cent of asset backing.
"There are some significant discounts and selective opportunities. On Challenger's metrics, the Australian-REIT sector is trading slightly cheap."
However, White expects this will remain so until the "elusive catalyst", likely in the form of a stabilisation of the debt markets, becomes evident.
Many fund managers have diversified their property funds but not all property has been severely battered.
In the March quarter this year, the total return for the S&P/ASX 200 Property Accumulation Index was 0.4 per cent, compared with minus 3 per cent for the broader S&P ASX 200 index.
White said while LPT returns - year to date were down 18 per cent for the quarter, March produced zero per cent returns. However, there are signs of a small bounce in pricing in recent weeks as index funds have bought into the market and some cash from dividends has been reinvested.
LPTs are currently delivering around 7.50 per cent yields and the Australian REIT index is trading around the 1700-1800 level.
A recent Russell Investment Group survey showed the portion of investment managers bullish towards LPTs rose from 9 to 22 per cent this quarter, and those bearish fell from 77 to 54 per cent - the smallest gap between the two in the survey's twelve- quarter history.
The survey also found that many managers are still negative towards LPTs because they have yet to demonstrate a compelling value proposition.
Many analysts also warn that there are still many LPTs with over 50 per cent gearing that are vulnerable in the reality of today's credit markets and movement in asset values.
What's around the corner?
Global property agents Cushman & Wakefield recently told the Financial Times that prime real estate in emerging markets may escape the current slowdown relatively unscathed.
They said ten of the top 15 fastest growing markets were emerging countries such as European hotspots Ukraine, Turkey, Bulgaria and Hungary.
Even in REITs there are trusts that have lower debt and good properties that are well positioned.
Standard and Poor's took no ratings action against 10 major Australian REITs with ratings of BBB+ and higher, judging that they are well placed to withstand the challenges of lower liquidity and financing costs.
And while there is re-pricing in the LPT market, there are also opportunities for investors.
White said history has shown that as the economy slows down and we reach a peak in the interest rate cycle, Australian-REITs generally perform better.
However, due to higher levels of leverage and increased levels of non-rental income this time around, we may see the strength of this relationship breakdown.
But White notes that Australian-REITs were the first hit in the financial crisis with downgrades in valuations and earnings.
Now, he says, we are seeing other financials being sold off in similar magnitude and earnings revisions in other sectors of the equity market have yet to turn significantly negative.
One glimmer of light is the office markets of Sydney, Brisbane and Perth, where rents are under market and there should be some growth.
Direct property and unlisted property fared much better, with investors averaging positive returns from direct property.
The Mercer Property Sector Survey for 2007 showed direct and unlisted property funds producing a positive return of 0.4 per cent.
And with all these adjustments, the market for LPTs, direct and unlisted property may have some attractive opportunities for investors looking for stable income.
But a recession in the US and the increased cost of debt will continue to make life difficult for all in 2008.