Brent Sheather: Property equation changes with debt

Two weeks ago we looked at a syndicated property scheme which was selling the public shares in the Bendon building on Airpark Drive, Mangere, and concluded that the listed property sector potentially had more to offer retail investors.

There is, of course, another alternative for people with enough money - owning a small office building, shop, industrial property or house directly.

Until recently most reasonable people who were not property experts would probably have rejected this idea out of hand on the basis of the potential advantages of listed property with genuinely independent price discovery, diversification, liquidity and professional management coming to mind.

But anyone looking at the recent dismal performance of the listed property trusts might think again.

In the past couple of years the share prices of local and Australian property trusts have fallen much faster than the actual value of the properties owned, as institutional investors have become nervous of the extent to which the property companies finance themselves by debt.

Property, the academics tell us, is supposed to exhibit lower volatility than shares. That hasn't been the case in the past 18 months - listed property around the world has fallen in value as sharply or more sharply than their respective stockmarkets.

In fact, despite much higher dividend yields, which suggested that listed property was a better value proposition, it was possible to do very much worse than buying the house next door and renting it out.

After all, residential prices in the year are only down about 10 per cent, yet the ING Property Trust (yes ING again) is down by 61 per cent and the Kermadec and National Property Trusts are both down by 49 per cent.

Individuals who bought listed property in the hope that it would provide a shelter from stockmarket storms will feel shell-shocked.

The big reason for the weakness in the property sector has been debt; specifically, too much of it.

Debt has fundamentally changed the risk profile of most of the local listed property stocks. While debt magnifies returns when prices are rising, it unfortunately has the same impact on the downside.

Nowhere has this phenomenon been more apparent than in the Australian property sector where the index is down by 73.7 per cent since the market peaked in November 2007.

Much of this decline is due to the fact that a few years ago Australian property fund managers fancied themselves as masters of the universe and started buying property all over the world funded by debt.

This looked like a no-brainer at the time because property prices were rising and the yield on the property was higher than the cost of the debt. What's more, the finance whizz-kids had risk management policies in place that protected against interest rates rising, which was a great move, except that interest rates went down, not up, so that the funds made huge losses on their interest rate swaps, which added to their gearing worries.

With the credit crisis the high borrowings game is over as property prices have fallen due to concerns about risk and rental declines on the back of weakening economies.

Many of the Australian property trusts went into the crisis with gearing of 50 per cent or more, which meant with a 10 to 20 per cent decline in property prices gearing could potentially blow out to 70 per cent, at which point the chances of actually refinancing the debt were called into question.

For this reason many Australian property trusts, despite owning prime property leased to the best tenants, are trading at huge discounts to NAV and retail investors who bought into the sector as a proxy for bricks and mortar have lost almost everything.

For example, ING Industrial Fund shares, trading at $2.35 two years ago, are now 16c despite the value of their property being $1.66 a share.

This trust has about A$6 billion of prime property, prime tenants and long leases but 60 per cent of its assets are funded by debt and the worry is if property prices continue to fall they will have to sell assets at fire sale prices to placate the banks.
New Zealand listed properties have performed better than those in Australia but the debt-inspired volatility is keeping many investors awake at night.

The tendency for property companies to have higher than appropriate levels of debt today is perceived to be one of the biggest weaknesses of externally managed property companies in New Zealand and Australia.

Many lower-risk, retired investors own property trusts for their income but for them even moderate levels of debt are most often inappropriate.

Their alternative, and thus benchmark, is 100 per cent equity financed ownership of a small commercial building, but in buying a listed company, Mum and Dad abdicate the financing decision to the fund manager. Why does the listed property sector have such high gearing?

One reason is probably because property fund managers are paid fees as a percentage of the value of the property that they own. Buying property funded by debt is a great way to increase their profitability.

This is a conflict of interest for property fund managers - they make more money from highly geared property companies and they control the financing decision.

Unfortunately, with the credit crisis, this game is over and in respect of some trusts, like ING Industrial, their fund managers have well and truly killed the goose that laid the golden egg.

The case for debt is that shareholders earn the spread between the cost of the debt and the yield on the property. But many of our local property trusts have debt costing 7 per cent a year and higher, so with property yielding 8 per cent or so there is not a lot in it.

Furthermore financial theory says there is no free lunch here - what you gain in terms of the spread you lose by way of higher risk on your equity.

On the subject of capital management, local and Australian listed property companies are frequently eager to issue new equity but rarely if ever advocate buying back stock when the fund trades at a meaningful discount to NAV.

In contrast, in the US, where most property trusts manage themselves rather than employing an external manager, buy-backs of shares are a lot more common. Why buy or develop a new building if you can buy your own stock back at a discount of 20 per cent?

The external property manager model in New Zealand and Australia is looking increasing at risk - property fund managers need to ensure that they stay relevant and when they make decisions they take unit holders' interest into account as well as their own.
Some traditional property investors have always been suspicious of owning commercial property via a listed fund versus owning it directly as they have memories of what happened in the 1980s. The latest crash in listed property prices won't do much to change their view.

What's more the current weakness plays into the hands of people selling unlisted property vehicles, like syndicates, which argue that listed property acts like shares rather than property.

That's wrong - listed property dances to the same tune as all other risky assets backed by cashflows, and rental cashflows are typically less volatile than company profits, unless, of course, you pile up the debt.

But debt changes everything. If the local listed property companies are ever to regain the confidence of retail investors they need to acknowledge that mistakes have been made (admittedly not to the same extent as in Australia), begin moves to remedy the high gearing and promise never to go there again.

At the moment the trust deeds of many listed property funds permit gearing as high as 50 per cent, which is like the sword of Damocles hanging over unit holders' heads.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.