Value in the AREIT Sector?

APN, April 2015

In this article we answer some recently asked questions about the value in the AREIT sector. We conclude that different valuation metrics are implying vastly different things. On balance, we believe that the market will still provide APN with the ability to deliver on its stated investment objectives. Accordingly, we conclude that (for our investment style and strategy), value still exists in the AREIT sector. We cannot say the same for more aggressive AREIT investment styles (including Index strategies) that by definition are investing in securities that are higher up the risk/return scale.

Are we comfortable about the relative value in the sector based on existing financial market metrics and the outlook for the yield curve?

• In many regards, the yield curve remains the issue. We are comfortable that the current consensus view of “lower for longer” will prevail. “Lower for longer” refers to the expectation that global growth and inflammation will be low for an extended period. This will feed into the Australian economy and result in yield curve remainig flat for an extended period. A flat yeild curve means that short term interests rates will perhaps mov lower (or at least be maintained at cuurent levels) while the “long end” (ie 10 year Bonds) will remain compressed based on a pessimistic outlook and the impact of sluggish offshore growth that impacts the US bond market particularly.  It is of course the US bond market  that substantially drives the trajectory of the Australian bond market.
• The reality is that low interest rates are a significant tailwind for AREITs at the moment. Steadily falling interest expenses have provided an earnings per share (EPS) tailwind for many AREITs.
• Low interest rates are a key driver of investor preparedness to bid up the market. Private clients who invest directly in the market compare the yield they can achieve in fixed interest investments (~2.5% – 3%) with the yield in AREITs (most yielding in the range of 5% – 8%). Institutional investors often utilise the 10 year bond as the risk free rate in the discounted cash flow valuation process. With the bond trading at all time record low yields, it is little wonder that many valuations support the sector current pricing.

What is the sector premium to NTA, and is this relevant?

• We are sceptics about the relative usefulness of Net Tangible Asset (NTA)which is used as a primary valuation tool. NTA is a distorted figure in the AREIT market due to the impact of stocks like Goodman Group and Westfield. Because these stocks include significant amounts of corporation earnings, they trade as significant premiums to NTA (currently around 70% – 100%). These two stocks alone represent around 29% of the AREIT market and therefore widely distort the overall market premium to NTA. It is worth noting that there are still a number of AREITs that trade below NTA.
• The other issue with NTA is the disconnect the exists between listed and unlisted markets. Equity markets look at and price assets well ahead of the physical markets. Indeed, equity markets typically are looking up to 12 months in advance. Property markets can be priced (in the worst case) up to 6-12 moths in arrears. Depending on an AREIT’s valuation cycle and because property valuers are compelled to us often out of date sales evidence when formulating their opinions of value, a property valuation may in fact be based on information that is up to 12-18 months out of date. Accordingly the difference in perspectives (between listed and physical property market pricing) could be as much as 24-30 months. In markets experiencing a rebound in values this of course means that comparisons between listed and physical markets can be problematic.

To read the full document, please click on the button below.