Company news

Recovery 2010-2012 vs recovery 1990-1995.....the similarities, the differences, the aftermath

In this month’s Hot Topic we compare the 2010-2012 recovery in global financial and property markets with the previous recovery of the early 1990s.

Before we examine the two recovery periods, it’s important to highlight a striking distinction between the two recovery periods - the Global Financial Crisis (GFC) was ultimately a credit crisis whereas the bubble of the late 1980s/early 1990s was a genuine property crisis. We explore this critical point of difference and shed some light on the expected AREIT journey over the next few years.

A recap on how the GFC surfaced

Most readers will understandably be weary of hearing about the GFC and its destructive impact on global economic markets which has dominated headlines over the past couple of years. However, let’s indulge in a brief recap of the key events that transpired in order to assess the way forward.

The root cause of the crisis can be traced back to US sub-prime mortgages. American banks were in a lending frenzy with low interest rates and large inflows of foreign funds (in particular from the Chinese investing into US treasuries). Banks began lending 100% of the purchase price (and in some cases higher to cover associated costs). Not only were banks lending beyond prudent levels, they were lending to less than credit-worthy borrowers – commonly referred to as NINJA loans (no income, no job, no assets). This zealous pursuit of lending created the perfect breeding ground for a dramatic financial crisis.

As residential values began falling in 2006, the outstanding debt soon outweighed the value of the associated property and refinancing became difficult (and more expensive). Defaults on mortgages skyrocketed. The looming catastrophe was glaringly obvious - a fall in house prices when banks were lending 100% of the purchase price would be devastating.

These mortgages had been securitised into Mortgage Backed Securities (MBS) and were widely held by financial organisations. After subsequently losing the bulk of their value, this resulted in a large decline in the capital of many banks and U.S. Government sponsored enterprises which led to a credit squeeze; the beginning of the contagion that spread throughout the world. Ultimately, questions regarding the solvency of banks and the financial system in general were raised, investor confidence was savaged and global stock markets fell heavily.

How the GFC impacted the commercial real estate market

When the GFC hit, the non-bank lending markets virtually shut down leaving bank finance as one of the few sources of available borrowings. This naturally led to a scarcity of debt and as a consequence, very few buyers of direct property. The relatively high gearing levels of REITs (that were a product of the boom years) were now a lead balloon as falling asset values magnified gearing levels, which in turn put bank covenant levels at grave risk of being breached. Not only was debt increasingly difficult to obtain, but for those fortunate enough to secure finance, it came at a significant cost as banks began hiking up their margins.

REITs faced two real options; sell assets into a falling market or raise equity at significant discounts. Neither option was attractive to equity investors, but the alternative (the REIT going bust) was far worse! Raising capital to rebalance debt levels was clearly the best option under the extremely difficult circumstances. In Australia, a remarkable $16.9bn of equity was raised between October 2008 and December 2009.

The early 1990s experience

The early 1990s were characterised by some of the familiar traits that seem to accompany all booms; freely available credit, relaxed ending conditions, undisciplined property development and rapidly rising property values.

As you can see from the below graph, in less than three years (from the December 1987 quarter to the September 1990 quarter), commercial property values rapidly climbed approximately 36%. With the benefit of hindsight, this boom was even more remarkable as GDP growth had been trending downward and consequently dipped below 0% clearly confirming a recession.

The difference between the 1990s and today

Today’s environment differs markedly from the 1990s. Most significantly, Australian commercial property did not experience a price boom anywhere near the severity experienced in the late 1980s, which can be seen from the chart below.

A look at the prevailing property market fundamentals of the time paints an interesting picture and again helps to explain why many doubted we were heading toward a property market downturn.

Let’s contrast the fundamentals between the two periods:

Peak to trough sector analysis

Office sector cycles

The chart below showing National Office Demand highlights that over the last 40 years there have been six major cycles. In order to normalise the data across time periods we will examine the ratio of net absorption to total office market size. The results, when measured on a per square metre as a percentage of total stock basis, show that the most recent decline is only the fourth worst in this time period. A further observation is that the duration of cycles have reduced from the mid 1990s. Prior to the 1990s they were 6-8 years in length; post they have been 5-6 years. A possible explanation for this is that the economy has become more globally focussed and diversified.

National Office Demand – comparison in sqm as a % of total stock

A case study - how Westfield and Stockland performed in the early 1990s recovery and the 2010-2012 recovery

The current rebound in REIT prices that we are experiencing is not unprecedented. As shown in the table below, Westfield and Stockland staged major recoveries from their trough levels in 1990. The total returns continued to rise even after the initial three year bounce.

To highlight the recent REIT price recovery, we followed the performance of the same two REITs (Note: Westfield now incorporates Westfield Trust, Westfield America and Westfield Holdings – but it still serves a useful purpose for comparison). The price rebounds again show a strong recovery as evidenced below in the table.

Whilst these stocks fell faster in the 2000s cycle, the rebound was just as fast. Another interesting observation is that the share prices troughed well before the overall economy in both periods. In this instance, the equity market acted as a much better barometer to the economy than the actual economic data of both periods.

The expected recovery

The risk profile of AREITs has declined significantly from March 2009. As most REIT managers have refocussed their attention on conservative rental income streams, AREITs are transforming back into the traditional rent collecting model with predominately Australian domiciled assets.

We believe a number of factors will support continuing price appreciation for AREITs:

• Reduced sector gearing to below 30% (from a high of 38% during 2008) may facilitate accretive acquisitions.
• Reducing debt margins will balance increasing base rates as a relatively attractive funding source.
The volatility of returns have been falling for over twelve months. Whilst volatility has not yet fallen to pre-GFC levels, it has contracted by approximately 75% and continues trending lower.
• The sector is trading slightly below stated Net Tangible Asset (NTA) values. This phenomenon may not last much longer as investors are more comfortable with asset valuations which is further supported by general market consensus that values have bottomed. Excluding Westfield, the sector currently trades at an even greater discount of circa 5% to NTA.
• The earnings yield spread to real bonds remains attractive at 1.70%.
• Strong possibility of new Initial Public Offerings (IPOs) helping to re-invigorate and broaden the sector’s asset base.
• Payout ratios will gradually revert to normalised levels and increasing yields will lead to stronger price performance.
• Merger and acquisition activity may return due to improving credit markets and improved gearing which will further stimulate pricing.

We expect total returns from the sector to be approximately 9-11% p.a. in the medium term.

Direct property markets remain broadly in equilibrium (from landlord and tenant perspective). This is the most important fundamental to watch and we expect confidence to progressively return over 2010 based on the following evidence.

• Retail –consumer confidence remains resilient and will probably continue to do so while unemployment is falling. Retail turnover growth is forecast to slow (while still remaining positive) as rising interest rates and the withdrawal of the Government funded fiscal stimulus package begin to take effect. Rental growth is expected to accelerate again in 2011 as a relatively benign supply outlook is expected over the next few years.
• Office – this market has traditionally been the most cyclical in nature. The 2010-2012 recovery is expected to be no different. With unemployment appearing to have peaked at 5.8% this cycle (June to August 2009) compared to many bearish forecasts of 9+%, employers may look to take more office space driving rents higher and decreasing the likelihood of increased occupancy. Employment prospects in the all important finance, insurance and real estate sectors have begun to improve. A silver lining to the GFC was the fact that no major supply overhang exists as most developers were starved of capital, preventing them from developing. The expected national vacancy rate is forecast by Jones Lang LaSalle to peak at 9.6% which is a far cry from the 20.3% peak in the mid 1990s.
• Industrial – demand for industrial space is still weak and is likely to remain subdued until the second half of 2010. Inventory stock has been running down since fourth quarter 2008 which has reduced the demand for space. Pleasingly however, this trend has now reversed with inventory growth turning positive (third quarter, 2009). With the economy recovering, it is expected that a cyclical swing back to inventory rebuilding will continue through 2010.

Final wrap

The causes of the last two market corrections were vastly different - an oversupply of assets in the 1990s versus undersupply of credit in the 2000s. Therefore it’s no surprise that the recoveries are equally different. What remains to be seen however is how the recovery period in the current 2010-2012 cycle eventually pans out for listed and unlisted commercial property. If AREIT payout levels return, M&A activity gathers momentum, debt costs and debt availability continue to normalise and accretive acquisitions commence then the rebound in AREITs is likely to extend and our “base case” estimate of total returns of 9-11% p.a. may well be exceeded.

However, before true confidence in AREITs is reinstated, direct property markets need to completely stabilise. We expect direct property to progressively stabilise over 2010.

Whilst the widespread fear and panic throughout the GFC would lead us to believe the end of the world was nigh, the events of this period were in reality nowhere near as severe as the early 1990s. As the all important fundamentals remain reasonably strong throughout the noughties, conversely they were fragile during the 1990s. This cycle is a credit crisis, not a property crisis and whilst we can’t be certain of how the full recovery of 2010-2012 will play out, the signs are encouraging. The AREIT sector has acted swiftly to confront this unprecedented period of global financial market upheaval and is now positioned on a more sustainable footing than prior to the GFC – AREIT balance sheets are in order, payout ratios (distributions to earnings) are lower, credit markets are stabilising, general economic indicators are turning positive and property fundamentals remain strong.