4 September 2012

Real estate investment trusts (REITs) – the sector formerly known as listed property trusts (LPTs) – may have lost many fans during the global financial crisis (GFC), but the sector can now mount a compelling case for reinstatement to favour.

The listed A-REIT sector was one of the biggest victims of the GFC, plunging 55 per cent in the 2008 calendar year alone: from the peak to the trough, the market value of the A-REITs index slumped by more than 70 per cent.

But even worse than the alarming unit price falls was the effect on the sector’s reputation. What had once been a solid defensive sector became more volatile than the market itself.

Until the GFC hit in 2007, REITs were considered a reliable source of high yields, being required to distribute all of their taxable profit to unit-holders. Most REITs usually paid out about 90–95 per cent of their profit as distribution, compared to about 60 per cent of the major listed industrial companies’ profit going out as dividends.

However, the REIT sector changed significantly over the 2000s: what had been a group of simple landlords passing on rental income to their unit holders, with profit coming from rental income minus expenses, became a much more entrepreneurial sector.

The stapled-security structure, where a share in a property company trades indissolubly with a unit in a property trust, became more common. The stapled securities were able to add earning streams other than mere rent collection; for example, property development, syndication, management and property services.

While these non-core activities increased the REITs’ non-rental earnings –thought at the time to be a good thing for their investors – the earnings streams they represented were a lot less predictable than rental flows. These non-core activities – and the lower-quality earnings they generated – also increased the REITs’ exposure to equity market risk

There was also the effect of financial engineering, fuelled by cheap debt: average gearing across the REITs rose from about 10 per cent in 1995 to 30 per cent in 2001 and then to 43 per cent in 2007.

Prior to the GFC, the average payout ratio of the sector rose above 100 per cent of free cash flow: that is, the funds were paying out more than they generated.

Flush with cash, A-REITs went shopping abroad: by the time the GFC hit in late 2007, about 37 per cent of the funds’ assets were located outside Australia.

The reckoning when the debt bubble exploded in 2007–2008 was painful. The liquidity of being listed made REITs far more readily saleable than other property assets, which led to the sector’s huge market slump. The REITs with a large percentage of offshore assets fared the worst in the market shock of the GFC. Some weaker funds did not survive.

However, the repair job performed by the sector has been impressive.

The REIT sector is now a smaller, more concentrated and more financially strong cohort of stocks. Since 2009, the A-REITs have raised more than $28 billion in fresh capital: although much of this capital was raised at depressed prices, and heavily diluted existing shareholders, the result has been a much healthier financial position for most trusts.

The sector’s gearing level has come down to 28 per cent, although the market has become distinctly two-tiered: the stronger REITs have an average gearing level as low as 25 per cent, while the less-robust REITs have a gearing figure substantially higher than the average.

Non-core businesses – and properties – have been sold. The focus of activity has largely come back onshore: overseas holdings now constitute just 20 per cent of the sector’s assets.

The changes to the A-REIT sector have been mirrored in other markets.

As REITs have re-oriented toward a more “back to basics” model, the correlation with equity market indices have come down – meaning that REITs, in Australia and globally, have regained (or reinforced) one of the main reasons for including them in a portfolio: the diversification benefits, both in terms of a source of return – an alternative or complement to the term deposit/fixed-income holding – and a diminution of overall portfolio risk.

The distribution flow to investors is once again almost wholly rental income, derived from multi-year leases, to high-quality tenants, often inflation-protected: this income base to a large extent neutralises short-term sharemarket turmoil. The sector’s volatility has returned to more normal levels. Payout ratios have come down from nearly 100 per cent at the market peak to a more sustainable level of about 80 per cent.

In Australia, the sector yield stands at about 6 per cent, with a small tax-advantaged component, which is not as effective in reducing an investor’s tax liability as fully franked dividends from shares.

It’s a stable – even boring model – but it’s back to what it should be: an investment that plays an important role in any properly diversified portfolio. That is as true in a global context as it is in an Australian-only portfolio, but extending a REIT portfolio into global markets does carry with it the need to make a hedging decision.

James Dunn is a financial journalist and media consultant. The views expressed are those of James Dunn, not necessarily those of Kelly Wealth Services.

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