GFC victims A-REITs to provide encore to stellar 2012 performance?

Financial journalist and commentator on 3AW and Sky Business
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Australian real estate investment trusts (A-REITs) were star performers last year, delivering a total return of 32.8% (S&P/ASX 300 A-REIT Accumulation Index) versus the market (S&P/ASX 300 Accumulation Index), on 19.7%.

More important even than performance, though, was the fact that after losing the plot in the GFC, the A-REIT sector is back doing what it is supposed to do – capturing rental cashflows and passing them on to investors.

The REIT sector was one of the biggest victims of the GFC, plunging 55% in 2008 alone: from the peak to the trough, the market value of the A-REITs index slumped by more than 70%.

But even worse than the alarming unit price falls was the effect on the sector’s reputation. What had once been a solid defensive sector became even more volatile than the market itself.

Until the GFC hit in 2007, REITs were considered a reliable source of high yields, being required to distribute all their taxable profit to unit holders. Most REITs usually paid out about 90–95% of their profit as distribution, compared to about 60% of the major listed industrial companies’ profit going out as dividends.

How it all changed

However, the REIT sector changed significantly over the 2000s: what had been a group of simple landlords passing on rental income to their unit holders, with profit coming from rental income minus expenses, became a much more entrepreneurial sector.

The stapled-security structure, where a share in a property company trades indissolubly with a unit in a property trust, became more common. The stapled securities were able to add earning streams other than mere rent collection; for example, property development, syndication, management and property services.

Market risk

While these non-core activities increased the REITs’ non-rental earnings –thought at the time to be a good thing for their investors – the earnings streams they represented were a lot less predictable than rental flows. These non-core activities – and the lower-quality earnings they generated – also increased the REITs’ exposure to equity market risk

There was also the effect of financial engineering, fuelled by cheap debt: average gearing across the REITs rose from about 10% in 1995 to 30% in 2001 and then to 43% in 2007.

Arguably worse was the fact that by 2007, the average payout ratio of the sector had risen above 100% of free cash flow: that is, the funds were paying out more than they generated.

Hand in hand with the debt load-up went a flush of overseas expansion: by the time the GFC hit in late 2007, about 37% of the funds’ assets were located outside Australia.

The reckoning when the debt bubble exploded in 2007–2008 was painful. Because they were listed – and thus more liquid than other property assets – the REITs took the brunt of panic selling. Those REITs with a large percentage of offshore assets fared the worst.

Return to tradition

But since the dark days of 2008, the Australian REITs have cleaned up their act.

They have rebuilt their balance sheets and reduced debt: average gearing across the sector now stands at 29%, with payout ratios at a far more comfortable 77%. Those that have overseas exposure have sold most of their problem assets: overseas holdings now constitute just 20% of the sector’s assets.

On average, about 80% of the REITs’ revenues come from passive rent collection from Australian commercial real estate.

The return to a more traditional structure and operation based on rent collection means that most of the REITs offer continuing high and comparatively stable income yields, derived from multi-year leases, to high-quality tenants, often inflation-protected.

This income base should neutralise short-term share market movements – but after the GFC, no investor should consider REITs as stable in a unit price sense. These stocks used to be known as listed property trusts – and “listed” is the operative word. They are not immune to a market slump.

However, the A-REITs have very largely regained the main reason for including them in a portfolio: the diversification benefits, both in terms of a source of return – an alternative or complement to the term deposit/fixed-income holding – and a lessening of overall portfolio risk.

The A-REIT sector is once again a strong candidate for a yield portfolio, with the provisos that the REIT distributions are typically untaxed in the trusts’ hands: they do not come with franking credits attached. There is a small tax-advantaged component, arising from tax concessions, such as depreciation allowances and tax-deferred income, which is not as effective in reducing an investor’s tax liability as fully franked dividends from shares – and in the SMSF context, does not give any augmentation of the yield to the SMSF in accumulation or pension mode.

Good yields

But given the diversification benefits of exposure to rental from blue-chip tenants of commercial, industrial, retail or office property, there are good yields to be found in the A-REIT sector.

For example, in retail, the 7.4% market consensus yield for FY14 offered by Charter Hall Retail REIT (CQR) and 6.4% FY14 yield for Shopping Centres Australasia Property Group (SCP) are attractive. In office property, the standout exposures are Commonwealth Property Office Fund (CPA), offering 6.4% in FY14, and Investa Office Fund (IOF), projected at 6.3% yield in FY14.

For a diversified exposure, Challenger Diversified Property Group – which has a portfolio spread across office (60%), retail (16%), Australian industrial (19%) and French industrial (6%) – is priced on a projected FY14 yield of 7.2%. Despite the absence of franking, this kind of yield suits SMSF investors well.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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