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Unlisted Property Trust portfolios – the upside follows downside

In this month’s Hot Topic, we examine the Unlisted Property Trust (UPT) component of the APN Property for Income funds’ portfolios which have been somewhat maligned over recent times. With many property and mortgage funds closing to redemptions over the past 18 months due to the illiquid nature of UPTs, it’s easy to see why they’ve been blamed for the woes of illiquidity. At APN we believe a more logical, long term (“through the cycle”) approach however, is to maintain perspective by analysing the merits of UPTs as an asset class within the context of a diversified portfolio.

We believe the UPT sector holds significant merit – with investor demand improving, a resilient domestic economy, buoyant demographics and stabilising valuations, Australia is one of the most self sustaining and attractive property markets in the world with strong fundamentals and significant growth potential.

For the purpose of this article we have amalgamated the UPT portfolios in the APN Property for Income Fund (PFIF) and the APN Property for Income Fund No. 2 (PFIF2).

It is worth restating the rationale for holding UPTs in the PFIF portfolios – quite simply, UPTs offer excellent long term diversification and return benefits to a portfolio. The benefits include:

• Diversity of assets (a bigger pool of assets to invest in rather than limiting investment choice to AREITs)
• Diversity of management (often UPT managers are not AREIT managers)
• Enhanced yield (at various points in the cycle)
• “Pure” property returns (income is derived from passive rental based earnings)
• Lower volatility (UPTs are not priced daily like AREITs or subject to the irrationality of share market traders)
• Greater direct property proxy (because pricing is based on asset values)
• Low correlation between listed and direct assets enhances portfolio diversity

Diversification is the outstanding benefit. If we examine the combined PFIF and PFIF2 holdings, the unlisted portfolio adds 37 more portfolios encompassing an additional 362 assets with multiple tenants. This enhanced level of diversity (properties, tenants and managers) significantly adds to the quality of the cash flows in the PFIFs which could not be achieved through investing in AREITs alone.

The following table illustrates the diversification benefits derived from the combined UPT holdings of the PFIFs.

Because UPTs are straightforward rent collecting entities with no active earnings streams (generated from corporate activity) and are not priced daily on the ASX, they deliver a more stable total return and have a low beta (correlation) relative to the AREIT sector. Lower volatility is a very attractive feature for any investor.

Investing in UPTs is akin to holding direct physical property but with the benefit of divisibility inherent in a UPT structure. (Divisibility being the benefit investors have from being able to buy units in a trust structure by accessing assets of a size and type that they would never individually be able to afford or access). Listed and unlisted property investments behave in different ways. Daily pricing of AREITs makes for a more volatile asset class. By combining the two assets we can reduce volatility and smooth returns while maximising the underlying property features in the portfolio which is illustrated in the below graph.

The relatively low passing yield of 5.4% from our overall UPT portfolio is a result of UPTs retaining earnings. This cash is being used to reduce debt as a result of credit rationing and the GFC. This prudent Balance Sheet management strategy will impact on NTA (ie. it will increase as debt reduces) however total returns should not be impacted (other than that due to reduced leverage). We expect that once credit market conditions normalise the yield from these UPTs will increase (higher distributions due to lower interest expense). The normalised yield is the dividend yield that the portfolio will deliver once distribution payouts return to normal levels (ie. retaining earnings cease).

Fundamentals remain sound

Critically, even after enduring the GFC (albeit a muted impact in Australia) tenants generally remain viable and continue paying rent. We have not witnessed a dramatic increase in vacancies (vacancy rate is currently 5.5% across the portfolio) or rental arrears.

Whilst gearing is higher than the AREIT average (circa 30%), the UPT portfolio weighted average gearing level accords with that of various AREITs that have not been able to access fresh equity.

The Interest Cover Ratio (ICR) remains secure at around 2.7 times. That is, for every dollar of interest the UPTs in our portfolios have to pay, they have 2.7 times the required cash available.

The debt expiry profile also remains appropriate (at 1.6 years) particularly if you accept the consensus view that debt markets will normalise and margins will reduce over the course of the next 12 – 24 months. If this view prevails then those entities that have maintained short debt expiries throughout this period of elevated margins will have superior earnings growth compared to those who have entrenched hefty bank margins for longer periods.

The Weighted Average Lease Term (WALT) offered by our portfolio of UPTs also remains attractive. Currently the WALT exceeds 5 years and reflects the number of secure long term leases in the underlying assets in the various UPTs.

Valuation upside

The Weighted Average Capitalisation Rate (WACR) reflects the assessment of value of each asset within each entity. Intuitively, the 8% WACR across the UPT portfolio fairly reflects the quality of assets and compares favourably (for an income investor) with the WACR for the AREIT sector (S&P/ASX 200 Property index) of 7.1% (Source: UBS).

The portfolio (summarised above) reflects the portfolio skew to domestic office assets (total offshore exposure is only 3% in the UPT portfolio). This reflects the generally lower risk, domestic focus that we have long targeted for our portfolios. With the move to offshore investments so prevalent in the AREIT market, it becomes apparent why unlisted property for an investor with a domestic focus (in a balanced portfolio) is so attractive. The portfolio also reflects an absence of corporate earnings. These riskier earnings sources are prevalent in AREITs but are totally absent from UPTs.

A rigorous investment process

Analysing what isn’t in a portfolio is equally as important as to what is in a portfolio because naturally the decision not to invest in any particular entity can be just as important as deciding not to invest in another entity. Our highly disciplined investment screening process has been proven in this regard with the PFIF portfolios excluding many UPTs that have performed well below par. The APN investment team is meticulous in their approach to investment decision making. By undertaking a detailed assessment of each potential UPT using multiple valuation tools and applying judgement against the backdrop of the broader local and global economic environment, we are confident in making the right investment decisions.

Outlook for unlisted property

There is now widespread acceptance that valuations have found a base. Vacancy levels in most major domestic office markets have begun to stabilise and the conditions are ripe for rents to stabilise and begin to rise. Strength in retailer conditions have also served to support retail rents and values, whilst early signs of renewed GDP growth and increasing inventories should benefit industrial property markets. Bank finance, although still difficult to obtain and expensive, is now starting to become more available and this should underpin current values.

Our expectation is that over the next 18 months we will start to see tentative signs of rental growth for commercial property leading to increases in capital values as capitalisation rates also begin to firm. We would expect this growth in value to accelerate in the medium term as a shortfall in supply (caused by lack of construction during the credit squeeze) starts to impact from 2011/12.

Because the unit prices of UPTs are directly based on asset values, UPTs are naturally a closer proxy for direct property than AREITs. Given we expect Australian asset values to start to slowly increase in the second half of calendar year 2010 any increase in value will be positive for investors’ total return. However, if the AREIT sector remains stagnant and we are unable to sell UPT holdings, the increase in UPT values will further increase the proportion of illiquid assets in the funds which only exacerbates the issue that caused us to close the funds to redemptions.

We firmly believe the PFIF portfolios contain quality UPT assets. We consider the discounts that are being applied in the pricing of the UPTs in secondary “markets” are an over-reaction – particularly as property markets are now starting to stabilise. Indeed, it appears that the secondary market for UPTs is now starting to reduce the discounts that were once expected and an increase in potential buyers means the market is becoming more liquid. Accordingly, we look forward to ongoing stabilisation in the UPT sector which is likely to occur through 2010 as the sector recapitalises (equity) and refinances (debt). With the recovery in AREITs over the last twelve months and improvement in the underlying conditions for direct property, we would expect to see unlisted property start to become the beneficiary as the cycle moves into its next phase.