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Finding undervalued Australian Real Estate Investment Trusts (A-REITs) in this market is tough after a stunning rally in 2014 and early in 2015. The sector looks slightly overvalued, but the prospect of further interest-rate cuts this year suggests the A-REIT rally is far from over.

Among smaller A-REITs, this column favoured Shopping Centres Australasia Property Group, BWP Trust, Charter Hall REIT, National Storage REIT, Asia Pacific Data Centre Group, Ale Property Group and Hotel Property Investments. GDI Property Group and Mantra Group were added to the list in February.

Another A-REIT, the Galileo Japan Trust, is also worth watching. Unlike many small-cap A-REITs, it trades at a significant discount to Net Asset Value (NAV) and offers exposure to the improving Japanese property market.

Galileo owns 19 properties in Japan; almost half are in Tokyo and a third in Kobe and Fukuoka. There are seven office, five residential, five retail and two industrial properties. The average occupancy rate in its portfolio was 96.6 per cent at December 2014, slightly down on the previous half because of a key tenant cancellation.

Vacancy rates in Japanese property are decreasing. Galileo’s latest investor presentation says vacancy rates in Tokyo eased almost 1 per cent in the second half of 2015. Consequently, average city office rents there rose 2.1 per cent in the half and are expected to rise steadily in the next 18 months, using UBS forecasts.

Galileo said: “Real estate market fundamentals for Tokyo office space continue to improve and fundamentals elsewhere are generally sound. Real estate lending conditions are supporting a more active transaction market and capitalisation rates have continued to firm over the past 12 months.”

Galileo reported a NAV of $2.15 in December 2014, down from $2.19 per unit in the previous half because of adverse currency movements between the Australian dollar and Japanese yen. Compared with the current $1.84 unit price, Galileo trades at a 15 per cent discount to NAV.

The market has re-rated Galileo this year. It started 2015 at $1.65, building on gains in 2014. Rising unit turnover is another good sign as more small-cap fund managers buy Galileo.

Chart 1: Galileo Japan Trust

Source ASX

As a $196 million A-REIT, Galileo suits investors comfortable with micro-cap trusts. Its exposure to Japanese property adds a layer of currency risk for Australian investors, and only 34 per cent of its portfolio (by value) was independently valued. The rest was valued by directors. Assets independently valued rose 4.4 per cent over the year to December 2014; those valued by directors rose 0.1 per cent for the same period..  

Galileo acknowledged FY15 earnings and distributions were sensitive to Australian dollar/yen currency movements. It maintained distribution guidance of 15 cents per unit in FY15, provided the AUD/JPY exchange rate remained around current levels (93 cents). With the Australian dollar expected to fall further this year, the AUD/JPY exchange rate could be a bigger issue for Galileo investors.

Galileo’s sensitivity analysis shows a $1.10 AUD/JPY exchange rate would reduce the current NAV to $1.91, still above the unit price but a much narrower discount than now.

Adverse exchange-rate moves would affect distribution in Australian dollars. At the current $1.84, Galileo should yield 8.1 per cent in FY15, based on distribution guidance. That is an attractive yield for income investors and it comes with the prospect of capital growth if the recovery in Japanese property quickens.

Galileo says it could enhance value by increasing net operating income on the portfolio as the Tokyo office market improves, selling non-core assets and recycling capital into new opportunities, and potentially buying back units if market conditions are favourable.

I like Japan’s prospects as the government’s massive quantitiative easing program and a falling oil price stimulate the economy. The Nikkei 225 index has rallied this year, continuing a bull-market rally since 2013. Investors have become more confident that the Japanese economy has stabilised and has plenty of tailwinds to drive medium-term growth.

Buying an A-REIT such as Galileo, with an expected 8 per cent yield, exposure to a recovering Japanese property market, and a 15 per cent discount to NAV, should entice value hunters. Galileo’s offshore property exposure also provides useful portfolio diversification given most small-cap A-REITs are heavily concentrated in Australian property.

But Galileo has added complications, notably around hard-to-predict currency moves and potentially higher volatility in Japanese property. Conservative investors should look elsewhere for yield. For those willing to look further down the market for income, without paying excessive valuations, Galileo has attractions.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at March 11, 2015.