A-REIT Sector – Defensive Phoenix Rising from the Ashes

Given the fact that A-REITS are required to return profits to shareholders in the form of dividends, they should act as defensive stalwarts in tough times.  Dividend yield coupled with share price appreciation has historically provided attractive opportunities for investors.

Then along came the GFC and the REIT sector turned out to be built of sand as the crushing weight of the combined forces of the crisis destroyed the sector.  Some REITS lost 70% of their value.

Despite the admonition to avoid investing by “looking in the rear view mirror,” the majority of investors cannot ignore the past.  Indeed, even seasoned professionals are mired in prior horrors, as evidenced by the constant comparison between today’s debt concerns and the Lehman Brothers failure.

While investing is about the future, not the past; only a fool would fail to consider the lessons of history.  So let us take a look at the disastrous demise of the REITS in Australia after the GFC.

What Happened to the REITS?

There are a growing number of financial experts now touting the comeback of the REIT sector, based on an understanding of the past and how the sector has changed.  Five factors are most often cited as explanations for what happened to the REITS:

•    Gearing

•    Payout Ratios

•    Property stgelopment

•    Construction Lending

•    Funds Management

A simplistic interpretation of these factors working together is this – they borrowed too much money to grow; paid out too much money to investors; and got into businesses that increased their risk.

A readily understandable way to think of REITS in the past was as landlords.  In essence, the business was about property ownership and management.  

REITS can be structured in two ways.  First, there are the stand alone trusts.  These are companies that restrict their business models to real estate investment properties – retail, industrial, office, residential, hotel/leisure, or diversified holdings – and their management, including rental, maintenance, administration, and property improvements.

The second structure is called a stapled security, where the real estate trust is joined or “stapled” to an additional company that provides funds management, asset management, and/or property stgelopment.

In essence, stapling opened up new business opportunities for REITS, but also posed additional risks.

Both types of REITS got themselves into deep trouble through gearing levels that proved to be unsustainable when times got tough.  Stand-alone trusts borrowed to acquire more property and the stapled securities borrowed like wild dogs to further the construction of massive property stgelopments, as well as to finance them.  

Some experts estimate the pre-GFC debt to equity ratio, or gearing ratio, was upwards of 40% on average.  Others say that figure is too low.  Whatever it actually was, it proved to be too high when the GFC led to the credit markets freezing up like Arctic glaciers.  Some investors do not realise that all companies constantly refinance their existing debt to get lower rates or better repayment terms.  This became impossible with the global credit crunch.

The final factor that contributed to the collapse was unsustainable payout ratios, averaging around 110% before the GFC.  You read that right.  On average, the REITS were paying out more in dividends than they were realising in profits.  How could they do that?  Gearing.

The REITS Today – What the Professionals See

At a recent investment advisor conference in Sydney – the Midwinter Adviser Roadshow – Daniel Needham, managing director for Ibbotson Associates had this to say to the 380 advisors attending the conference:

•    “We think Australian REITS are one of the best sectors to invest in right now in Australia.”

In its September 2011 Australian Corporate Sector Outlook, Moodys Investors Service issued a “stable” rating for A-REITs.  They point out that sector gearing ratios have lowered dramatically and anticipate increased share buy backs since most A-REITS are currently trading at about a 25% discount to net tangible assets.

Finally, Moody’s’ forecasts continuing unemployment around 5% and GDP growth of between 3% and 4%.  According to them, this will support demand for industrial and retail space, while a solid outlook for white-collar employment will underpin the office market.

The REITS Today – What Market Participants See

With gearing ratios now averaging around 30% and payout ratios at 77%, the market may be catching up to the positive outlook for the sector.  For the terrible month of August which saw a decline of 2% in the ASX, the Australian REIT Sector (XPJ) rose 3.1%.

The torrid pace continued into September, with the XPJ rising 4.9% for the week ending September 2nd.  

These returns came in the face of a wall of worry over European debt concerns and the possibility of global growth slowing and grinding to a halt in the west.  When you couple the high yields of the REITS with capital growth through share price appreciation, you are looking at the potential for defensive investments that can substantially outperform bank deposits of any kind, even at Australia’s higher interest rates.

REITS Today – Defense for the Average Investor

Given this background, the average investor can start a search for attractive REITS with dividend yield.  There are many other factors to consider, but without a yield of at least 4%, the possibility of beating a safe banking deposit at 6% becomes difficult at best.

Using a stock screener, we came up with the following list of the highest yielding REITS in Australia with analyst coverage:

Researching any share can be difficult but the challenge is even greater with REITS.  The stapled REITS – and most of the REITS on the list are stapled – have complex structures and have diversified their sources of funding, adding an additional layer of complexity.

While it is tempting to simply begin an analysis with the highest yielding shares on the list, there are other numbers we can look at to help determine which shares warrant a deeper look.  Here are the same REITS, with some additional information you should know:

Think of this list as a treasure map.  Where do you begin to look for gold?

If you are an investor that likes to trade with specific rules, you might be tempted to throw out those shares with above average gearing ratios.  On the face of it, LLC at 115.4% and WDC at 90.9% might not seem to warrant a single extra minute of your precious time digging into their particulars.  In addition, both ALZ with a 93% payout ratio and GMG with a 100% payout appear to be candidates for quick elimination.

Yet if you look at the final row in the table, you can see that every one of these shares has multiple analysts with buy recommendations.  

There never is any substitute for doing your own “due diligence” and REITS are no exception.  If your risk tolerance is medium to low, you can begin your research with SGP and CHC, the two shares that appear to have the best combination of low gearing and payout ratio.

You should first look for the business model of these two REITS.  What are they invested in?  Are they diversified?  How are they funded?

Right now you know the residential property market is softening.  The best defensive play for medium risk tolerant investors might be the shares with maximum diversification in the kind of property assets they hold.  

If they are in both residential and office space; what percentage of their revenue comes from each business group?  But even those measured are only starting points.

Next week we will look deeper at CHC and SGP.  In the meantime, if you have a few spare moments, you might want to do some research on your own. 

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