Investment Matters

Property valuations rising, with an exception

Whilst the focus in the press this week has been around the outlook for residential property valuations, Investment Matters this week will consider valuations of non-residential property.  This will include a closer look at what we are seeing in relation to the retirement space – Aveo in particular.

All reference to property below specifically excludes the residential sector.

How we look at property valuation

The factors investors consider when looking at property valuation are:

1/  Capitalisation rate (or cap rate) – this is the rate of return a property is expected to generate.  Simplistically, it is calculated by dividing the net operating income (rental income minus operating expenses) generated by the property by its current market value. 

The higher the quality of the property, or the more favourable the position, the lower (generally) will be the cap rate.  And office properties tend to have a lower cap rate than industrial ones due to factors such as the greater capital invested in the property and the location.  Investors will generally accept a lower rate of return from such properties.

2/  Yield - usually calculated as the gross rent divided by the asset value.  Operating expenses are not included in this calculation.  This is something to be wary of as, for instance, older office properties often have high maintenance requirements.

3/  Discount rate – this is the rate applied to factor in the time value of money.  It is used when calculating the valuation of a property using the NPV (net present value) method.  NPV calculates a valuation based on the future cash flows (rental receipts minus expenses) expected to be earned from the property.

Generally the 10-year government bond rate is used as the baseline for the discount rate, with investors deciding what percentage in addition to this is required to account for the risk of the investment.

Minor differences in the discount factor can have a large impact on the valuation ascribed to the asset.

Linking all of the above together – it can be seen that bond rates impact the discount rate, which in turn impact the yield and cap rate of a property, and ultimately its valuation.

What we have been seeing in recent years

Property cap rates versus bond rate

Source: MSCI/IPD

As shown the graph above, after the GFC related upheaval, cap rates have been on a decline.  This is in parallel with, as expected, the decline in bond rates.

What will the uptick in bond rates mean?

Further increases in the bond rate, which we do expect to occur, will likely impact property values.  A rise in bond rates will likely trigger a rise in cap rates, and thus a fall in property valuations.  Rental growth will act to offset this pressure.  The net impact is hard to predict, but certainly one of the reasons for our conservative approach in relation to property currently is because of risk in this area.

Discount rate – a simplistic example

As mentioned above, a small change in the discount rate can have a meaningful impact on the asset valuation.  The following table provides a simple example of that impact:

dcf valuation

 The retirement sector, and Aveo specifically

Aveos discount rate not moving with bond rates
Source: Aveo Financial Statements, IRESS

You can see from this graph that even as the bond rate (and cash interest rate) has been falling since the GFC, Aveo has kept its discount rate the same.  That was until the FY-16 year when it used a range of 12.5% to 14.5% (we understand that the 14.5% was used for the assets it gained ownership of as part of the Freedom acquisition in Feb-17).

What does this mean?  If Aveo had moved its discount rate downwards, more in line with the bond rate (as most other REITs have done), its asset valuations would have increased, along with their average cap rate.

Instead, Aveo has specifically chosen to not move its discount rate down.  This reflects the conservative approach that Aveo has chosen to take (which it also does more broadly).  We understand that by taking this lead, Aveo has helped to keep a lid on valuations across the retirement sector.

Although this isn’t ideal in the short term, especially when comparisons to other property investments are made without considering the discount rates, it is a sound approach in the longer term.  There may be pain coming in other property investments as bond rates and interest rates rise.  However, Aveo has a buffer against this.

This also emphasises that the argument made in recent press reports that Aveo is making excessive profits from the fees it charged is fundamentally flawed.  It generated a conservative ROA (return on assets) of 6.3% in FY-16, with a target of 5.5% - 6.3% in FY-17, and 7.5% - 8.0% in FY-18.  These are by no means excessive returns for security holders.  And furthermore, if Aveo had lowered its discount rate more in line with the bond rate, the ROA would be even lower.

Conclusion

The retirement sector has gone nowhere in relation to property valuations.  This is in contrast to other sectors including office, industrial and retail (shopping centres), where valuations have been trending up since the GFC.  The trend of increasing valuation has also extended into adjacent sectors, such as daycare centres and student accommodation.

The notion that excess returns are being generated by Aveo (or generally within the retirement sector) is not borne out by the data.