Hugh Dive, Head of Listed Securities

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Tales from the Trenches - What's going on in Listed Property

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Over the last twelve months, listed property has been the "quiet achiever" in most investors' portfolios. Whilst Australian equities have faced concerns about a rising and then falling AUD, falling commodity prices, global growth and a financial system inquiry, listed property has sailed under the radar and the index has posted a total return of +28% over the past 12 months bettering equities by 20%! In this note we will look at what is going on in listed property together with our positioning in the various property sectors.

What's driving performance?

The charts below illustrate the one and five year performance of LPTs vs equities. After tracking Australian equities throughout 2009 to 2011, listed property has outperformed equities over the past 3 years due to solid performance in 2012 and 2014. In 2012 the sector was up by 33% due to a number of catalysts, namely under-valuation, reducing interest costs, extensive buy-backs below net tangible assets (NTA) and high relative yields.

Listed-Property1.JPG a1sx2_Original1_Listed-Property2.JPG
   

In 2014 the listed property sector has been largely untouched by macro concerns. The falling AUD boosts Westfield Corporation's offshore earnings and decreases the attractiveness of global internet shopping while the falling oil price is seen by the market as positive for domestic retail spending. Further the last 12 months has been a banner year for corporate activity (and investment banking fees) with the Westfield demerger, Colonial Retail Trust management internalisation, two new metropolitan office trust IPOs and the Colonial Office Trust and Australand takeovers.

Foreign buyers continued to be especially active in the Australian property market in 2014, purchasing nearly $5B worth of commercial property or about 40% of the value of properties that were sold. This interest is primarily confined to the office market in Sydney and Melbourne, with little foreign buying of retail and industrial property. According to the RBA the source of this buying has been foreign developers and investors with a spike in sovereign wealth fund investment. The effects of quantitative easing have kept interest rates low and buoyed the interest in Australian commercial property. The excess liquidity has opened up property earnings yield differentials between Europe (3.4%) and Japan (2.4%) and Australia (6.5%) and has boosted the valuations of Australian property trusts.

Residential property comprises a small portion of the listed property index, but generates emotive newspaper headlines. Foreign Investment Review Board and RBA data shows that foreign investment in Australian residential real estate has risen from around $6B annually in the 1990s to more than $17B in 2013 with 2014 expected to be close to $33B. Unsurprisingly the data shows that foreign purchases appear to be mostly concentrated in new rather than established dwellings, in higher rather than lower-priced dwellings, in medium and high-density dwellings rather than detached, and in inner-city areas of Sydney and Melbourne rather than other locations. This has not only provided a boost to residential developers such as Mirvac, but has led Dexus to sell lower grade office buildings to developers for residential conversion and Goodman to re-zone industrial property for residential use.

Around the grounds

Discretionary Retail (58% of LPT Index)

Discretionary retail continues to face the challenges of digital competition to bricks and mortar, reduced tenant margins due to increased price transparency, and rents increasing faster than sales. Retail malls will not become redundant, but will continue to evolve as they have in the past. However, we do not expect the same growth as achieved over the past five years. It is clear that the trusts will have to change their mix of tenants to maintain profitability. Whilst occupancy across the retail sector remains strong at 99.4%, this has come at the cost of lower income growth and negative re-leasing spreads (new tenants negotiating rents per m² below that of the departing tenant).

Staples Retail (5% of LPT Index)

In contrast to discretionary retail, non-discretionary (smaller neighborhood food and liquor) landlords are still achieving positive rent spreads (+3%) vs the discretionary landlords that reported negative spreads (-4.6%) in August. In the portfolio we favour landlords owning neighborhood supermarkets that are exposed to Australian consumer spending on staples (food and liquor). Whilst this doesn't involve owning assets like glitzy shopping malls with lots of fashionable retailers, we prefer the more stable returns from consumer staples.

Office (16% of LPT Index)

Office trusts are dealing with deteriorating white-collar employment from financial services and government employers, the rise of "hot-desking" which is reducing the space requirements per person in new buildings/ refurbishments and substantial new supply in Sydney and Melbourne. Overall the Australian CBD office market continues to look weak (11% vacancy and 20-30% incentives being given to new tenants), but the market has ignored this and focused on corporate activity and rising asset values. A good example of this was REST Super's purchase of 52 Martin Place for $555M in July, which equated to a yield of a mere 5.2%.

Industrial (17% of LPT Index)

Whilst the industrial sector has enjoyed cap rate compression that has led to higher asset prices, this space could be tougher in the future as increased supply hits the market (+500k m² in Brisbane and Melbourne, +700k m² in Sydney under development). As mentioned above, the industrial trusts are generating profits from re-zoning industrial property to residential. In 2014 $470M of industrial property has been sold to residential developers.

Residential (4% of LPT Index)

Whilst the residential market in Sydney and Melbourne has been very strong the major residential developers Mirvac and Stockland have slightly underperformed the index in 2014. This is primarily due to stock specific issues, the market views that Stockland is acquisitive and may overpay for assets at the top of the cycle and Mirvac's 2015 guidance issued in August was substantially below market expectation.

 

The Property Trust sector as a whole appears to be trading at a premium to fair value. The catalysts that propelled the sector up over the last three years have largely been played out. The sector currently trades at a +25% premium to net tangible assets (excluding Westfield Corporation), 14.8x forward PE and 5.7% yield. Our portfolio strategy of populating the portfolio with higher quality domestic rent collectors, rather than developers has outperformed in 2014, as it did in 2013. Further, the focus on trusts that are delivering recurring yield results in a higher distribution yield and lower earnings volatility for investors.

Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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