Opportunities in A-REITs?

As is typical during panic, prices for Australian Real Estate Investment Trusts (A-REITs) overshot on the downside in early 2009, declining 36% and it was then that our interest was piqued.

The reasons for the unravelling of the property boom related to over leveraging.  I’ll spare you the history lesson but will say that the siren sounded on highly geared and heavily structured investment vehicles with the collapse of Lehman Brothers.  The systematic pullback in lending left the sector with no option but to raise capital to repair their bloated balance sheets.  So, are current values compelling enough to get us interested?  Let’s run through some valuation metrics to show you our thinking. 

Prior to A-REITs adopting highly leveraged and complex financial structures, the sector was renowned for its steady income.  But with the current average forecast yield of just 5.7% this is hardly exciting enough to compel us to invest.

Another reason one buys any asset is because it is undervalued and could be held until the market recognises the mispricing.  The A-REIT sector, though, is now trading at prices close to the asset value ascribed by their independent auditors.  Our research did, however, identify some exceptions.

The one metric which makes the sector look attractive is replacement cost.  High government levies, increasing building materials costs and credit terms for developers which are prohibitive to new development mean that many assets are priced well below replacement cost. One recent research interview with an A-REIT manager highlighted properties that were priced at roughly half their replacement cost.

Had the sector not had to issue so much new capital to repair its collective balance sheet during the financial meltdown both yield and asset backing metrics would look very attractive right now.  But the fact is they did issue equity, and a lot of it. 

Simply trading below replacement cost, in itself, is not enough to compel us to buy.  In our view, the sector looks like ambling along at a low growth rate for some time.  The one caveat being if credit markets thaw - this would enable funding of consolidation activities and the associated speculative activity.

Elton Doyle, February 2010