This article is from the Australian Property Journal archive
Over the past five weeks the property investment universe has been focusing on the LPT sector’s reporting results with more than two-thirds of LPTs presenting their 1H06/CY05 performance by 1 March 2006.
With the S&P/ASX Listed Property Trust Accumulation Index generating a solid 11.1% return over the 1H06 (six months to 31December 2005), this is the time when investors pour over LPTs’ reports and conclude whether all the hype has been justified.
So far ING Office (IOF), Centro (CNP) and Mirvac (MGR) are among the stronger than expected results, with ING Industrial (IIF), Investa (IPG), Valad (VPG), Thakral (THG), Macquarie Countrywide (MCW) and Multiplex (MXG) disappointing.
In fact, MXG’s extreme negative growth figures have caused a bias in all reported numbers in this editorial. As such, we believe it appropriate to dampen this “MXG effect” by halving its weight in the calculations and apportioning the balance to all other LPTs covered in a proportionate manner.
Earnings growth weaker than Distribution growth
So far in 1H06 the sector has recorded continued strong DPS growth at 3.2% (4.4% Dec’04 and 5.8% Dec’03), but weak EPS growth at -1.0% (6.8% Dec’04; 7.4% Dec’03). EPS growth disparity among the sectors is evident with solid retail (+4.2%), healthy industrial (+2.3%), recovering office (-0.1%) and weak residential and construction (MGR -10%, MXG -342%).
The major highlights of the 1H06 reporting period so far have been: (1) deterioration of quality of earnings composition with a material elevation in levels of lower quality earnings in order to meet previous guidance, including asset disposals and irregular transactional fees, (2) increasing reliance on development income, (3) IFRS-based reporting making its debut, (4) property fundamentals tracking well.
The sector is currently trading at a +2.7% premium to our assessed fair value, offering a 12-month forward yield of 6.6% with a FY06-FY11 average distribution growth forecast of 4.1% p.a. Our forecast 12-month total return is 6.2%. Pitiful income growth has not stopped some LPTs from distributing more than they earn.
For example, groups such as Macquarie Goodman (MGQ) and Westfield (WDC) have payout ratios in excess of 100%, with MGR’s ratio being at 100%. MGQ has now reduced this back to parity (expected in 2H06 post Arlington), with WDC announcing last week a reduction of this to around 100%. Trusts such as ING Office Fund (IOF) and Macquarie ProLogis (MPR) have also now reduced their payout ratios below 100% to ensure distributions are not raised to unsustainable levels. MGR has not hinted to a possible reduction in the near term.
especially with Overseas LPTs
All the rage in 2005 was about investing overseas. The argument was that with little remaining un-securitised product domestically LPT fund managers would need to look to overseas markets for growth: vast, untapped and starving for management expertise/capital.
The hype has yet to be justified. Earnings growth from domestic LPTs (we define these as deriving more than 50% of their income from Australian property operations) outstripped their international counterparts by a substantial 10.8%. Overseas LPTs however, managed to close some of the gap at the distribution line by, among other things, undertaking financial engineering (currency swap markets.)
For example, there are currently four trusts with capital hedging income. This income provides, as a proportion of earnings, over 1% of Macquarie Office’s (MOF), under 9% of MCW’s and Centro Retail’s (CER), and 10% of Babcock & Brown Japan’s (BJT) EPU. These lower-quality and higher-risk earnings make the internationals’ operations appear better than they really are. Even so, they still look pretty ordinary.
while Internals also failed to justify their more aggressive stature.
Stapled LPTs are considered more aggressive and more diversified to boot, as they generate income for a wider variety of sources, although the 1H06 results (to date) indicated that their external cousins can still outperform them. (Having said that, the “MXG-effect” is behind this observation, again.) Stapleds’ diversity also provides more space for cosmetic enhancements.
Thus, for example, Valad Property Group (VPG), Investa Property Group (IPG), ING Industrial Fund (IIF), and Multiplex Group (MXG) all had a noticeable decline in earnings composition.
In conclusion, not only was reported EPS growth negative for internal vehicles, the majority of EPS composition was derived from items such as (1) recognition of development profits on land transfers to managed funds (IPG, MGR) and development site disposals (MXG), (2) recognition of development profits under IFRS, (3) profit on asset sales (IPG), and (4) dependence on transaction fees (VPG). Some of the weakness in external LPTs’ results can also be attributed to GAN’s and CPA’s expensing of significant responsible entity performance fees ($3m and $2.4m respectively), an issue not relevant to the internal/stapled vehicles.
Retail sector commentary
A theme of slowing Moving Annual Turnover (MAT) sales has surfaced, especially in 1H06. The lag between MAT sales and retail LPTs’ rental performance was especially highlighted. For example, there were reports of slowing sales although LPTs’ rents have not been impacted (yet) by these slowing sales. Whether this lag will also ensure strong FY06 numbers is uncertain of course, and presupposes that conditions do not deteriorate significantly during the next four months.
Comparable income growth is likely to remain in the 3-5% range (1.5-2.5% for Galileo Shopping Centre America (GSA), Centro Retail Trust (CER), and Macquarie DDR Trust (MDT)). Development returns of more than 8% are still being generated and likely to continue over FY07. Trusts that PIR believes will show particularly strong Jun’06 retail results are: Westfield Group (WDC), Centro Property Group (CNP), General Property Group (GPT) and Stockland Group (SGP).
Industrial sector commentary
We acknowledge that land prices have been under upward pressure (leading to double-digit growth in reported NTAs). Strong economic conditions and infrastructure bottlenecks around the country (more pronounced in NSW and QLD) have also led tenants to industrial areas with quick access to major arterial roads or close to ports, many of which are owned by LPTs.
This in turn has supported growth in rents and, subsequently, reported earnings. However, rents have not increased across the board by enough since the previous corresponding period to justify the present euphoria with Industrial LPTs. As such we expect stable industrial markets, with 2-3.5% comparable income growth possible. We therefore see no compelling value in any of the industrial funds (even allowing for funds management activities) and do not recommend additional investments in any.
Hotel sector commentary
Although THG reported weaker-than-expected results, Macquarie Leisure’s (MLE) Visitor Numbers were materially up for its entertainment assets. Grand Hotel Group’s (GHG) results (reports in mid March) are anticipated to provide more robust figures with Revenue per Available Room (RevPar) expected to increase strongly within GHG’s hotel portfolio.
This is not surprising given the cathartic response of earlier conditions, especially on international arrivals: SARS, the bird flu outbreak (a lingering threat), terrorism, a strong AUD, and the relentless increase in the price of oil. The Tourism Forecasting Committee (TFC) estimates international visitor arrivals in 2006 to slow moderately, yet remain robust, with growth of 5.6 per cent to around 5.9 million. Resident departures are forecast to rise 6.6 per cent to around 5.1 million in 2006. So while most of the upside is likely to come from within Australia most of the downside is likely to come from offshore.
Office sector commentary
Among the biggest question marks likely to be in investors’ minds is whether office LPTs have finally turned the profitability growth corner. PIR’s opinion is not yet. Although, to be sure, 1H06 income growth was positive (albeit below inflation), and LPT managers made a lot of noise about how lease incentives are slowly but surely creeping down, and should not even be necessary in 12 months’ time, investors shouldn’t be transfixed.
Conditions may have improved, but reported earnings growth was still mediocre relative to other sectors. Gross rents may be creeping upward but effective rents did not go anywhere, at least not in 1H06 (FY06 may be better). Organic growth from their struggling property portfolios is still a dream.
So while we do expect recovering office markets domestically, with 2-3% comparable income growth, this may be based more on enhanced tenant retention rates, reduced releasing periods and decreasing incentive levels rather than genuine growth. LPTs with office portfolios that are likely to benefit most from positive sentiment are, in PIR’s opinion, MOF, IOF and GPT.
Development sector commentary
Development margins have been eroding, particularly of the residential variety. Under IFRS, profit recognition on development projects will be lumpy, depending on timing of settlement. The 1H06 reporting season is proving to be mixed for those players with residential exposure.
The Land Subdivision and Land & Housing market (SGP, IPG) is improving in most states. The Apartment market (MGR, SGP) is struggling in terms of sales volumes and building costs. Geographic exposure is the key to outperformance over 2006 with those primarily exposed to NSW (i.e. IPG/MGR) likely to continue facing difficult conditions (continuing affordability issues, particularly among first-home buyers, coupled with below-average population growth).
On the other hand, LPTs with exposure to WA (MGR, SGP – resources boom shows no signs of abating), SE QLD (supply moderating, above-average population growth and development-friendly local authorities) and, to a lesser extent, Victoria should outperform.
By Peter Papadakos, REIT analyst for Property Investment Research.*
