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 MARKET REPORTS |
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Analyst report - LPTs
LPTs still hot property?
October 1, 2007
Brendon Lau, ShareAnalysis
The listed property trust (LPT) sector has outperformed the broader market since the start of the market turmoil two months ago. This is due to defensive buying and strong results posted by a number of LPTs. Unfortunately, this strong performance means that there are not many bargains left in this space. Nonetheless, we believe select buying opportunities remain.
Considering the US economy is at the centre of a credit crisis, LPTs with substantial US exposure have weathered the storm on global financial markets surprisingly well. The exceptions are Centro Properties Group (CNP) and its satellite fund Centro Shopping America Trust (CSF), which have lost around 8% each since late July.
This is partly because CSF posted a 6.9% drop in EPS from a year ago, while CNP delivered an NPAT that was 22% below our forecast. Currency movements, goodwill, special distributions and AIFRS accounting adjustments have also negatively impacted the NTA of both companies.
Meanwhile, NTA values for other LPTs have been boosted by the compression in capitalisation rates. Overall, we believe cap rate compression for all sub-sectors is slowing and will become a less significant driver of NTA growth in the future.
Growth for the sector is more likely to come from strong development activity, growing funds management businesses and merger and acquisition (M&A) activities. We believe property trusts with strong development pipelines are well placed to capture any upturn in the property market, given the shortage of investment-grade assets and development land across Australian CBDs. A number of companies, including DB RReef Trust (DRT) and Macquarie Office Trust (MOF), have announced significant initiatives in this area.
On the funds management front, we continue to see such activities, and the recycling of capital is attracting increased attention among the largest LPTs. Given the sustained focus on capital recycling and the creation of further annuity management fee income, we expect to see an increasing number of funds and joint ventures being created by the larger LPTs.
The latest credit squeeze has not dampened enthusiasm for M&A activities in this sector. Cromwell Group (CMW) has publicly stated its interest in Mirvac Real Estate Investment Trust (MRZ) and, just last month, CNP proposed a merger between two of its listed trusts - Centro Retail Group (CER) and CSF. This merger will create a $4B market cap trust to become one of the ten largest LPTs by market cap.
These developments follow a string of M&A activities in FY07, which were dominated by cash bids by Morgan Stanley Real Estate and Prologis Group, both of which were successful in acquiring Investa Property Group (IPG) and Macquarie Prologis Trust (MPR), respectively.
Over the next 12 months, we are forecasting modest average returns of between 7% and 8% for real estate stocks. Although this is significantly below the forecast returns for other stocks in the Financials sector, we believe a few LPTs can still deliver total returns in excess of 20%.
Cap rates explained
When valuing stocks, investors often use price metrics such as price earnings ratios and earnings per share. When it comes to property valuations though, you often hear the term “capitalisation rate” being used. Knowing what this means will help you better understand property-related investment reports.
The capitalisation rate (or cap rate) is generally used as a means for estimating market values for income-producing properties. A basic calculation for the cap rate is total net operating income divided by the cost of the underlying asset. The cap rate is normally expressed as a percentage and is sometimes referred to in layman terms as a “yield”.
If you know the cap rate and net income generated, you can estimate the value of the property in question. For example, if a property investment generates a net annual income of $10K and the cap rate is estimated at 10%, then the value of the property is $100K ($10K/0.10). If the cap rate falls, the value of the property rises.
Falling cap rates have lifted the net tangible asset (NTA) values of most LPTs over the last several quarters. As mentioned in the earlier article, we do not believe cap rates will fall much further and LPTs will need to improve net operating incomes to drive growth.
While it is relatively easy to understand what impacts net operating income, you might be wondering what affects a property’s cap rate. One factor follows the property market adage “location, location, location”.
In prime locations, we expect investment properties to have low vacancy rates as demand often outstrips supply. From this perspective, investors would be more willing to pay a little more for the stability in cash flows. This typically translates to lower cap rates (or yield) for properties in desirable areas and vice versa for those in less sought after locations. Thus, a cap rate could be used to help gauge the level of earnings risk across various property assets and to highlight instances where property assets are over- or under-priced.
Cap rates are usually calculated for specific markets rather than for individual properties. Properties in areas where there are higher sales turnover (meaning a more liquid market with greater buying and selling activity) will produce a more robust cap rate. Such data is usually available from a property appraiser or financial reports of listed property trusts (LPTs).
As with all data, investors should examine the assumptions underlying the cap rate calculation. For instance, there are several ways to calculate net operating income and it would be futile to compare the cap rates between properties if income calculations are inconsistently applied. Other considerations include the impact of expiring leases and occupancy rates.
In our valuation of LPTs, the cap rate is not usually a significant factor. We use our proprietary discounted cash flow (DCF) model on all the stocks we cover, as this gives us a consistent basis to compare the attractiveness of LPTs as an investment with shares in other sectors.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
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Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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