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AREIT Reporting Season Wrap – Half year 2010: More positives than negatives

Reporting season was completed during February and the results were broadly as expected. In summary:

• Australian based portfolios remained resilient relative to weaker offshore located assets;
• Asset values in Australia stabilised, with a general acceptance that the valuation down cycle is finally at an end; and
• Australian assets proved to be more stable than US and European equivalents.

Debt and liquidity are no longer the risk. Indeed, signs of lazy balance sheets reflect the reality that perhaps some AREITs raised too much equity in 2009. The cost of excess debt capacity (line fees etc) came into question as the focus generally moved from Balance Sheet to Profit and Loss.

On the broader economic front, the December quarter business indicators and current account data point to an Australian economy that is returning to normal growth. Imports are rising as businesses rebuild inventory levels and generate improving profits. As the economy grows, we expect to see stronger sales growth, rising profits and at least a stabilisation of inventories. The Australian economy has been remarkably resilient amidst the dramatic global financial events of the last few years which thankfully now appear to be behind us. Unemployment is falling, credit availability is improving, inflation is under control and demand for commodities is improving. These positive factors all contributed to a further 25 basis point RBA rate increase to 4% on 2 March 2010.

Key themes and issues

↓ Gearing

AREIT balance sheets have improved markedly following recent recapitalisations. AREIT gearing now averages circa 27% which is down from a peak of around 43% with most trusts displaying ample gearing covenant headroom. Debt facilities expiring in the short term are now also less challenging than they once were, with many expiring debt facilities pushed out to 2012. AREIT managers will endeavour to increase the duration of their debt facilities from the current 3.5 year average by seeking alternate longer dated sources of credit. AREIT interest cover stands at 3.3 times earnings, well above the average debt covenant minimum limit of 1.9 times earnings. ING Industrial Fund exhibits the least headroom, with ING Office Fund and Stockland reporting ample headroom at 6.1 times and 4.0 times earnings respectively.

↓ Distributions and earnings (DPS & EPS)

The large capital raisings conducted over the past twelve months combined with deleveraging, occupancy weakness, rising interest rates and mixed rental growth outcomes led to weak earnings per share (EPS) and distribution per share (DPS). However, earnings should begin to bottom out post the 'rebasing we had to have'. Westfield and GPT were the clear disappointments from reporting season. Westfield was the main culprit in this regard. A revision of distribution guidance from 67cents to 64 cents which was driven by a higher interest expense was the key issue that disappointed market expectations.

→ Valuations

Capitalisation rates (an indicator of property values) and Net Tangible Assets (NTA) are stabilising. As reported capitalisation rates deteriorated slightly, pleasingly AREIT managers publicly indicated that valuations have now bottomed in Australia (globally, valuations are in the process of bottoming). NTA declines were also modest circa 5% down on average, leaving many stocks trading at double-digit NTA discounts. AREITs with offshore assets displayed the largest NTA falls. The sector’s average capitalisation rate now stands at circa 7.7%, a 125 bps rise from the 6.4% level reported during the market peak back in December 2007. Retail property sector capitalisation rates were well supported, at an average of 7.0%, with office at 7.8% and industrial at 8.7%.

The stated objective for many AREITs during reporting season was to acquire prime Australian assets. Refocussing on Australian assets is music to our ears and endorses APN’s mandate. AREITs coupled with the ever increasing appetite shown by global sovereign funds to invest in our shores should ensure that values are supported going forward. The only curve ball may come from Australian banks should they choose to put private investors as well as over-leveraged unlisted trusts “to the sword”. Under this scenario secondary assets as opposed to prime assets, would feel the pinch.

→ Operating metrics

Pleasingly, vacancy levels remain relatively low in Australia, with retail occupancy at 98.9%, office at 95.0% and industrial at 96.1%. Conditions are generally weaker offshore – for example Westfield's US occupancy stands at 92.8% and general US office occupancy is circa 84%.

Comparable Net Operating Income (NOI) growth in all subsectors in Australia showed signs of slowing in the period to December 2009. Offshore portfolios suffered the most due to ongoing macroeconomic weakness pervading the region. As an example, the US portfolios of ING Office Fund and Westfield were down 18.1% and 3.9% respectively.

The divide in operational performance between Australia versus the ‘Rest of the World’ was glaringly obvious and is best illustrated by looking under the Westfield hood and comparing the various regions in which they operate. Like-for-like NOI growth was 5.9% in Australia and New Zealand, negative 3.9% in the US and negative 4.2% in the UK. Importantly, the outlook for offshore real estate earnings continues to be reasonably benign relative to Australia, even though there are signs we have navigated the worst. Westfield provided the market with the added surprise of cutting their earnings by more than expected. The following chart indicates the relative strength of Australian property markets and the weakness of the US.

↑ Development Focus

It appears most AREITs have had a change of heart (aka strategy) as offshore assets were being divested in 2009 and focus returned to Australia (at least for now). The biggest mover of them all was the one time behemoth GPT having quarantined the bulk of its problematic offshore joint ventures off its balance sheet. GPT is now promoting its Newcastle town centre development as well as the next stage to Melbourne Central. Others to also flaunt their domestic pipeline of developments were Westfield, Colonial Retail Trust, GPT, Dexus, Commonwealth Property Trust, Goodman's and ING Industrial Fund.

↑ Australian Retail Sector

Retail was once again the standout performer showing signs of healthy rent growth, clearly benefiting from the near 100% occupancy levels. Australian retail was also a huge recipient of the flow through impact of fiscal stimulus in 2009, handing retail landlords a free kick.

↓ Australian Office Sector

Although landlords highlighted an increase in tenant inquiry levels, occupancy levels suffered a little over the period. An increase in rents beyond 2011 is a distinct possibility, a factor of the limited supply of new office space added to current stock as development was severely hampered by the inability to access finance. Incentives are currently at historically high levels between 20% to 30% in Melbourne and Sydney but these tenant ‘gifts’ are anticipated to recede in line with a recovering market.

↑ Australian Industrial Sector

Industrial operating metrics didn't fair too badly, clearly showing up the doomsayers. In fact, all AREIT industrial owners pointed to a pickup in activity for the pre-committed development market. Importantly, we did not see an increase in tenant delinquencies or a savage reduction in rents. The anticipated rebound in global Gross Domestic Product (i.e. global growth) is clearly in the industrial sector’s favour. The uplift in economic growth projections has translated into improved demand in the transportation and logistics sectors as retailers look to rebuild depleted inventory levels.

↑ Residential Sector

Residential earnings have begun to rebound as evidenced by Stockland's record sales over 2009. Both Stockland and Mirvac pointed to a rise in sales volumes, a consequence of Government grants, low historical interest rates and a housing shortage that doesn't appear to be abating any time soon. Both AREITs hinted at bringing more residential projects on line in the near term.

From here we can identify a reasonably steady outlook for AREITs. However, risks still need to be carefully balanced against potential upside:

• Developments are not yet firing on all cylinders
• Lazy balance sheets
• Continued restrictive bank lending
• Rising interest rates
• Sovereign debt issues
• A slowdown in global growth and/or China pull back

• Improving macro environment
• Stabilising capital values and property fundamentals
• Muted new Initial Public Offerings
• Accretive acquisitions
• Evidence of credit markets reopening and falling bank margins
• Continued resilience of the Australian economy
• Improving consumer and business sentiment
• Improving investor confidence

At APN, we prefer AREITs that are trading at discounts to our assessed NTA. This is an approach we’ve been advocating for some time based on our view that rationality would ultimately return to markets. We expect the gap between current share prices and NTAs will begin to close as more investors become comfortable with stated property values. We expect total returns from the AREIT sector to be in the range of 9-11% for the calendar year 2010 with returns predominantly derived from income.

In summary, the 2010 half year results can best be described as sound. And although the reporting season didn’t delight us with a stream of positive news, the relatively few disappointments was good news in itself, especially considering 12 months ago the Index was at 550 points (now 880+), the future of many AREITs was bleak, fear pervaded the market and headlines around the globe indicated the world was about to end. As we emerge from the Global Financial Crisis, we approach the year ahead with caution due to the ongoing fragility of the global economy but remain upbeat as the market is ripe with positive attributes. For the AREIT market, we believe the upside potentials outweigh the negatives.