US interest rates & Australia's hot industrial property sector
This week, volatility continued post the US Federal Reserve interest rate non-event last Thursday. In this edition of W&D, we consider the seemingly unrelated industrial property market in Australia. And show how the two are linked. Please work with me on this - it will be worthwhile!
REIT valuation example
Ascendas, a Singaporean listed REIT (i.e. Real Estate Investment Trust aka listed property trust) has, in Australia's largest industrial property transaction, purchased a portfolio of 26 industrial warehouses for $1,013b. The assets are mostly on the east coast of Australia (one in Perth), with tenants including Wesfarmers (Coles and Kmart), Toll, Pacific Brands and Nestlé. They provide a headline property yield of ~6.4%, or $64.5m net property income p.a. (net property income = rental income minus property outgoings).
A yield of 6.4%, allowing for risk, appears low on first consideration. In addition to the acquisition costs and fees (a significant $64.8m), the acquirer plans to bring in its own property management team. Costs such as these will bring the realised yield down below 6.4%.
Risks the acquirer would normally consider include (but are not limited to):
- Tenant retention and tenant default - the portfolio has quality tenants on long leases (average lease expiry is 6.1 years at 30-Jun-15) in good locations, so this risk is quite measured.
- Exchange rate (considering the acquirer is based overseas) - AUD denominated debt will provide a natural hedge, and the acquirer can consider their remaining risk in the context of their overall portfolio currency risk, and adopt additional hedging if warranted.
- Regulatory and taxation changes (e.g. land tax) - Australia is generally considered low comparative risk in this area.
- Funding costs - both an opportunity and a risk - see below.
Making the deal work
So we return to the seemingly unrelated US Fed (US Federal Reserve = US central bank, equivalent to our RBA) decision to leave interest rates at close to zero percent. This, along with quantitative easing measures (e.g. bond buybacks) implemented by the Europeans and Japanese, is widely considered to be creating an abnormally low interest rate environment across the world.
These low interest rates facilitate deals such as the above. Entities can gear up, using low cost debt, to acquire assets.
If we consider a back-of-the-envelope calculation for the acquisition above:
It is actually possible, in the short term anyway, for acquirers to a generate a respectable return in this world of ultra-cheap debt. The chase for yield, as we have seen for Australian blue-chips and REITs, is alive and well in other geographies too.
In the long term, however, asset prices predicated on ultra-cheap borrowing costs are not sustainable. The US Fed is doing a stellar job at delaying the inevitable (some Fed members are indicating a rise before the end of the year - but even then interest rates will still most probably be very low at somewhere between 0.25% to 0.5%).
Until interest rates are set at a level where capital allocation and investment distortions are not perpetuated, deals such as the above will continue. This will also push valuations up (because valuers use comparative transactions as an input to value properties).
Let's consider a scenario whereby interest rates are at a more 'normal' level:
Now not so attractive for security holders...
And this would inevitably lead to a re-rate (down) of property valuations.
So, although Australian commercial property prices are not astronomical relative to other countries (residential is another discussion), valuation risk is real both in Australia and overseas. Low interest rates are likely to persist for an extended period of time. However, conservative property managers will be mindful to the valuation risk of interest rates normalising.