Investment Matters

Property companies' profit reporting season

After each company profit reporting season, we provide a summary of how our clients' allocation to property securities performed.  It is that time again.  (For those without a property allocation, please stay tuned for W&D next week - when we return to more general investment matters.)

Overall reporting season for the property investments was in-line with our expectations.  We do, however, retain a conservative positioning.

General thoughts

Firstly, to the conditions being experienced by the REITs (i.e. Real Estate Investment Trusts aka property trusts).  Positively, incentives in the Sydney office market seem to be decreasing - although they are still high.  Additionally, there is some increase in demand (office and industrial) from companies that benefit from the lower AUD (tourism related; specialty manufacturers; educations service providers; etc).  However, resource influenced markets (Perth, and to a lesser extent Brisbane) are seeing more challenging leasing conditions.   Overall, business confidence is not strong, and economic activity is moderate (at best).  Thus, in general, real or realised rents (e.g. without incentives) are challenged.

We are wary of the sustainability of distributions.  Some REITs are paying out more in distributions than the free cash flow they generate - a huge red flag.  Pressure on realised rental income (as discussed in the previous paragraph) is a driver of this. The cost of debt (higher debt payments = less money to pay as distributions) will be an overlaying risk in future periods: availability of debt (not just the RBA cash rate) is driving this.  We are also seeing a notable trend to include at least part of the funding mix from longer tenure overseas sourced debt (e.g. US private placements), providing some diversification away from the Australian banks.

Property revaluations have been generally positive, which has flowed through to higher net asset per security values.  Whilst this is positive, we aren't getting too excited - as this is sometimes driven by comparative valuation methodology i.e. what other similar properties in the area have transacted for.  Overseas buyers have been able to purchase Australian property at quite high prices (office and industrial), because they have a very low cost of debt, and because they are able to accept a low yield in Australian terms (but an acceptable yield in their county of origin).  We view valuations using comparative transactions methodology as risky.  Over time (and it could take some time) we think that property valuations will revert to being based on the discounted value of the future earnings (the fundamental way all asset valuations should work).  In effect, at the moment we are seeing a mismatch between property valuations and the real rental return that those properties generate.

In relation to retail property exposures, we remain cautious.  Tenants have been pushing back on retail landlords, both in relation to lease costs and fitouts, as well as the general costs associated with being in a shopping centre.  We think this has some way to go, and expect more pressure in this sector (which will be even more the case if retail conditions deteriorate - they have been quite resilient to date).  We remain comfortable with the two retail exposures in the property allocation - Charter Hall Retail because of its strategic geographical positioning, high portion of long-term anchor tenants that underwrite income streams, and quality management.  And Westfield USA (not Australia!) for the premium its high-end centres can demand, and for its development opportunities (as well as providing some USD diversification).

Our positioning

Our approach in relation to property investments remains conservative.  We look for investments where rental income underwrites the distributions to investor.  Some development of funds management income is also acceptable, but rental returns should be the core.  We also look for balance sheet resilience, i.e. sustainable gearing / level of debt.  The ultimate goal is to provide our property allocation clients a sustainable income stream, plus some capital growth over time - as a hedge against inflation.  As such, performance is not measured against the ASX property index (XPJ).

We also retain the long-term investments (and would like to find more!) in property and infrastructure related bonds, as well as a property hybrid security (Goodman Group is the issuer).  Currently the cash position is 9.6% in the property allocation. 

A summary of the reporting season results

The following table summarises how each of the listed property trusts / companies performed.  It should be noted that "in line" with expectations is exactly what we are after in this more conservative allocation.