Property tipping point?
Dexus, a large ASX listed REIT (real estate investment trust), is attempting to take over the Investra Office Fund (IOF). Dexus and IOF both own Australian office assets, principally prime and A-grade in east coast CBDs. The offer has been made at a 5.2% premium to IOF's net tangible asset (NTA) per security.
The Independent Directors of Investra Funds Management, IOF's responsible entity (manager, in effect) have recommended that IOF security-holders accept the Dexus offer. Security-holders vote today as to whether they will accept the offer, with 75% of security-holders needing to agree for the takeover to proceed.
Developments this week
Cromwell acquired a 9.83% stake in IOF (Cromwell is a holding in First Samuel's property allocation). It is now unlikely that the Dexus takeover will proceed (as Cromwell and Morgan Stanley, with 8.9% ownership, will likely vote against. And it will not take many more security-holders to vote against for the 75% threshold not to be reached).
Cromwell's end game is not clear. There are various options that could unfold assuming the takeover vote is unsuccessful today. Cromwell may seek management rights over the Investa fund, thereby substantially increasing its funds' management income stream. It may target direct ownership of some of the funds assets, or some sort of transaction between IOF and Cromwell. Or it may just remain an investor in IOF, receiving the distributions as all other security-holders do, which will in turn contribute to Cromwell's distributions to its security-holders. We expect that, after the vote (assuming it is unsuccessful), this will become clearer.
First Samuel's thoughts
In W&D of 18-Mar-16, we reflected on the conservative positioning of our clients' property allocation. Briefly, there is a mismatch between property valuations, and the income streams that those assets are generating (driven largely by comparative property valuations, which in turn has been influenced by overseas-based investors). Additionally, we have increasing concern about the sustainability of distributions.
We are starting to see the mismatch in valuations being reflected in yields. The below graph from JLL depicts the falling yields, escalating over the last year. After all, yield reflects income in proportion to property value.
Source: JLL Research, Australian Office Investment Review & Outlook March 2016
Our views in relation to the property sector have not eased. If anything, because of developments such as credit tightening, our caution has increased further. We see tightening of credit flows (and a likely resultant increase in the cost of debt) as a risk for the property sector - especially as there are a number of REITs who are pushing the limits in relation to their distribution payouts. For a number of REITs, increased cost of debt would make their distributions unsustainable - which we believe the market would punish heavily.
This draws us back to Cromwell's move this week, and the Dexus' takeover more generally. This type of activity is perhaps a marker of a peak in the property cycle. The last time this group of (undoubtedly prime) assets was last fought over was in 2007 and the cap rate implied by the Cromwell purchase price this week (we calculate) is just under 6%. This is a lower rate than at the top of the last cycle, albeit interest rates of course are much lower in 2016 than they were in 2007.
We believe it is a reflection that direct investment in assets (i.e. Dexus or Cromwell purchasing individual properties) is hard - probably because of the competition from overseas buyers, and buyers overall. We can not predict (no one can) the specific timing of the property cycle, but our caution is heightened.
As such, this week we have been reducing investment in two of our clients' property holdings (if you have a property allocation that is). One of the holdings has become too expensive. The second is a more growth orientated investment and the risk and valuation balance has well, become unbalanced, in our assessment.
Obviously, we will continue our monitoring and review of Property allocation's holdings as developments occur.