A-REITs have learnt GFC lessons

A-REITs, which comprise some of the largest and longest-standing companies in the country including Westfield, Stockland and GPT, are forecast to return to growth either this year.

Morgan Stanley forecasts 4.8% growth for A-REITs in 2011 while Russell Investments says there will be modest growth in 2012.

The GFC was the catalyst for this turnaround in fortune.

Lessons learned from the global crisis resulted in many A-REITs, which had transformed from low-risk, stable investments to higher-risk, high-return, to head back to their low-risk roots.

An analysis of distribution trends in the sector over this period tells an interesting story.

A-REITs traditionally relied on rent collected from their investment property portfolio as the source for distributions to their shareholders. This provided predictable and reliable – albeit modest – returns.

Over time, other income streams were introduced by A-REITs to boost earnings growth and deliver better returns to investors. These include development, management, offshore investment and financial engineering.

Earnings growth predictably became the key focus for many A-REITs as the environment of predictable, low-yielding returns was abandoned in favour of bigger numbers designed to boost share prices.

Cheap debt

An influx of cheaper and easily accessible debt in the capital markets provided the fuel for this focus on earnings growth to develop.

Higher debt to equity ratios enabled rapid expansion into other service lines such as development.

The increased use of leverage also enabled distributions to be supplemented by debt. For A-REITs paying 0.25% per annum interest on their loans, debt was cheaper and easier to source than equity.

At the same time, asset values were on the rise as companies – again through the increased use of debt funding – could afford to pay more for assets. Favourable asset revaluations then allowed for loans to be refinanced. In hindsight, things were spinning out of control.

Other factors were also at play. The introduction of the International Financial Reporting Standards (IFRS) in 2005 created a fundamental change. All of a sudden the “movement in fair value of investment properties” was reported in the profit and loss statement, not on the balance sheet.

Positive revaluations were labelled as profit.

While the rationale may have seemed sound in a growth market, this reliance on debt was to prove unsustainable.

By demonstrating a preference for delivering higher payout ratios for shareholders - as opposed to preserving capital for reinvestment - many A-REITs were unknowingly painting themselves into a corner.

Despite the positive ramifications on share price and the greater potential for successful equity raisings, the swelling debt profiles of many A-REITs were making them extremely vulnerable.

Debt as a dirty word

Then came 2008.

Triggered by the sub-prime mortgage crisis in the US, the GFC established debt as a very dirty word.

Despite consistent cash flows, asset devaluations meant A-REITs were now reporting losses – and often they were big ones. The sector began to experience gearing ratio difficulties with lenders. There was a rush of capital raisings at a time when competition for investors’ dollars was high and confidence in the market was at an 80 -year low.

Whether the property market in general, and the A-REIT sector specifically, has recovered from the GFC is a point of conjecture.

We cannot expect A-REIT share prices to reach the lofty pre-GFC heights as they were then inflated by debt-supplemented distributions and should not be used as a benchmark.

What was most concerning about the transformation in A-REIT distributions over the last 10 years was the switch to focus purely on short-term earnings growth. The sector considered it better practice to use debt to fund distributions than acquire assets which could provide future income. This practice was only sustainable while asset values were going up. The possibility of a fall in asset values doesn’t appear to have been considered by the A-REIT managers.

Return to a positive framework

Fast-forward to the present day and the framework for the A-REIT sector is much more positive. Senior management is most concerned with stability and security.

Lessons surrounding the increased availability of debt appear to have been learnt.

A-REITs have changed their policies to allow distributions to be paid from only cash profits instead of shifts in asset valuations. Capital management is of paramount importance and long-term sustainability is the new black.

For A-REIT shareholders who have weathered some topsy-turvy times over the last few years, this should be music to their ears.

Laura Cummins is a research analyst at Cushman & Wakefield. She is the winner of the Australian Property Institute Project Prize for her final year thesis in which she investigated changes in A-REIT distributions over the past decade.