It is getting harder to buy direct or listed Australian property. Values are elevated despite a sluggish economy and the prospect of higher unemployment. Property fundamentals need to improve in 2015-16 to reduce the disconnect with valuations.

Consider the Australian Real Estate Investment Trusts (AREIT) market. On some measures, it is trading 5-10 per cent above fair value, as measured by the sector’s net tangible assets (NTA). That is not excessive in a market where the stocks of banks and utilities are also overvalued.

But nobody makes money buying overpriced assets in the medium term, or justifying decisions on the basis that one sector is less overpriced than another. Also, relying on sector-wide valuations can be dangerous given wide valuation dispersions among listed property.

Several larger AREITs, and some smaller specialised ones, are trading 30-40 per cent above their asset backing. The market is factoring in significant growth in their property values and growth strategy, and some, such as National Storage REIT, may deliver.

This column has done well with a string of small- and mid-cap AREITs and property companies in the past 18 months, notably Shopping Centres Australasia Group, BWP Trust, National Storage, Hotel Property Investments, Mantra Group, GDI Property Group, and the Asia Pacific Data Centre Group. However, care is needed with AREIT valuations at these levels.

That is not to say these or other AREITs cannot continue to rally in 2015. The prospect of another interest-rate cut, possibly two, this year will drive more investors from cash into higher-yielding equities. Stocks sensitive to interest rates and the so-called “yield trade” have further to run.

But it is usually better to take profits a little too early than too late, especially when investors have enjoyed stellar total shareholder returns in the above AREITs over one year.

My base-case scenario is for the Australian economy to muddle along for the next 18 months with below-trend growth – enough to avoid recession, but not enough to fire up demand for office, retail or industrial space.

Property, banks and utilities typically underperform in periods of economic weakness because of their higher debt and leverage.

Consequently, I am increasingly looking overseas for property opportunities, or for AREITs that have a higher proportion of United Sates rather than Australian property. Record-low interest rates are conducive to higher property prices, but the key is being able to buy assets below fair value. More opportunities are emerging in the recovering US market and further expected weakness in the Australian dollar this year boosts the case to hold offshore assets.

This column last week outlined a positive long-term view on the US Masters Residential Property Fund (URF), which was the first Australia-listed property trust established to invest directly in US residential property. It invests in undervalued neighbourhoods in growth markets that are within an hour’s commute of downtown Manhattan.

Another AREIT with US assets, RNY Property Trust, warrants investigation at current levels. It is  the first AREIT with a primary strategy to invest in commercial office property in the New York Tri-State area, and has a 75 per cent interest in 20 properties. It listed on ASX in 2005.

RNY, a higher-risk AREIT, does not suit conservative investors or income seekers. The $88-million AREIT has a high level of gearing (65 per cent), does not pay a distribution, and has relatively low unit liquidity. In the latest annual report, released in late March, RNY said it was cautious about the 2015 outlook because of uncertainty over the pace and sustainability of the US economic recovery.

Occupancy of 75 per cent in in the December half, down from 78 per cent in the June half, reinforces RNY’s challenge to let space.

Chairman and CEO Scott Rechler wrote: “While some measures of economic stability have returned to the US economy, high vacancy rates are still commonplace throughout our suburban markets. However, there have been some encouraging signs in our suburban markets as rents have stabilised and landlord concessions to tenants have decreased. But we don’t expect positive absorption to occur until the employment situation in the US has a prolonged recovery and businesses start expanding and hiring again.”

The main question, as always, is price. RNY has lagged other AREITs in the sector’s rally over 18 months: the one-year total shareholder return is 15.5 per cent. The AREIT sector has a 34 per cent total return over 12 months. Over five years, RNY has a 25 per cent annualised return, Morningstar data shows.

Chart 1: RNY Property Trust

Source: ASX

RNY’s 34-cent price compares with an NTA of 54 cents per unit in December 2014. Its NTA in US-dollar terms fell from 48 cents in December 2013 to 44 cents a year later, but was helped by the lower Australian dollar.

RNY should trade at a discount to NTA. Higher gearing and limited room to move on asset sales, due to debt covenants, is an issue. And RNY says it has challenging portfolio expirations over the next two years, with almost 20 per cent of the core portfolio leases expected to expire. The risk is the NTA heads lower during that period.

A bright spot for RNY is debt maturities in 2016 and 2017. That should allow it to refinance, recapitalise or sell assets and lower debt and gearing. If all goes to plan, RNY could sell assets as the US economic recovery quickens, and have balance-sheet flexibility to buy other properties.

Clearly, RNY has a tricky two years ahead. But a 37 per cent discount to NTA will look excessive if it can maintain or improve occupancy in that period, fix its balance sheet, and benefit from gradual improvement in the US economy and New York Tri-State office market.

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Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any 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 April 23, 2015.