Aussie REITS hit trouble overseas

Liquid Real Estate, Euromoney magazine, June 2008

For years, Australia’s listed property trusts have been going global. And until recently, it seemed like a good idea: diversified revenues, lower borrowing costs, yield enhancement opportunities. But as the credit crunch has wreaked havoc in the LPT market, it’s generally those trusts who ventured offshore who have been hit hardest.

Australia’s LPT market – or A-REITs, as the Australian Securities Exchange re-christened it this year to fit in with global terminology – is made up of 69 trusts with a combined market cap of A$103 billion as of April 30, according to the ASX. It’s a sophisticated market, one that has gone through many changes over the years, from expansion, to consolidation, to changing business structures and rising gearing. One key trend is that the assets that make up those trusts have becoming more and more global by the year, and today international holdings make up 44% of the sector, according to UBS, with the US alone accounting for 33%.

The drive overseas has been a long time in the making (Westfield, the biggest and arguably most successful property trust in Australia if not the world, has been in the US since 1978) but has been pushed forward by several trends in recent years.

For a start, there’s the shortage of assets left in Australia to put into trusts. “Over 65% of what we call investment grade assets – those worth at least $10 million – are already held by trusts, listed or unlisted,” says John Freedman, real estate analyst at UBS in Sydney. “So as people have sought to grow their businesses, they have moved offshore.”

Then there’s the fact that domestically, in Australia’s high interest rate environment, earlier this decade the cost of debt started to exceed the yield available from the property that could be bought with it. “Offshore, that wasn’t always the case: there was often a positive spread,” says Freedman. And additionally, offshore acquisitions gave managers the opportunity to structure their foreign exchange arrangements in a way that enhanced the yield. “In that market at that time, yield was highly sought after in whatever form it came,” says Freedman. “It encouraged the offshore move as well.”

Stephen Hiscock at specialist property fund managers SG Hiscock & Co in Melbourne recalls: “It started initially with the move to the US; then when the pricing got difficult to justify it moved to Europe and Japan, and it really stopped 12 months ago when the cost of funding exceeded the initial yields and made it less of a compelling argument. The only place where it continued to be compelling was Japan” – and three Japanese LPTs appeared on the ASX in 2007 alone.

From Hiscock’s perspective, the move offshore both “served the LPT sector well and did it a disservice. It was two pronged.” On the positive side, it provided an outlet for growing allocations to LPTs, absorbing excess liquidity. “And by far the bulk of tie-ups Australian managers have had with overseas managers have been with highly reputable organisations with high quality assets,” says Hiscock. “That’s a positive.”

But there is another side to it. “Where the whole thing came undone was partly the higher levels of gearing taken on board, and obviously the credit crisis stopped everything in its tracks,” he says. It’s not that international holdings are punished more than domestic ones per se – anything with high gearing has been hit – “but as a general rule the international ones have borrowed more, because borrowing in offshore denominated currency served as a natural currency hedge, and initially the cost of debt was quite low compared to the initial yield available on the properties,” says Hiscock.

For some, the strategy has worked perfectly well. Westfield Group, for example, has a market cap of A$34.6 billion, much of it achieved by sensible and successful expansion into the US. “Those groups who exported their IP, their skill set, like Westfield, have done very well,” says Freedman. “Those who didn’t have any real IP in real estate have done less well.”

Two in particular have struggled so far. Centro Properties Group is a retail property investment group with over 800 shopping centres, most of them in the USA. It has two listed property trusts, Centro Properties Group and Centro Retail Trust. Last year it had A$24.9 billion in funds under management worldwide. The group also has a direct property syndicate division, and two direct property funds, both of them open-ended and unlisted, as well as two open-ended wholesale funds. In short, a big and successful business.

But in December Centro said it had been unable to roll over A$1.3 billion in short term loans expiring in February, and the time since then has been made up of a stock market rout (77% in a couple of days), a change in CEO and a constant battle with various lenders to gain more time to pay back debt. An agreement in early May to extend two facilities ($2.3 billion owed to Australian lenders and US$450 million owed to US private placement noteholders) to December makes it look more likely that Centro will survive, but the process has been painful to say the least. “Every day it survives and the credit market settles down it has a greater chance,” says one analyst. “But at some point, in order for the banks to get their debt back, you have to unwind the structures involved there. At some point you have to detangle the spaghetti.”

Another that has hit the headlines for the wrong reasons is Rubicon. Part of Rubicon’s problem has been its parent: it is owned by Allco, which ran into its own subprime-related debt problems and has defaulted on margin loans. But Rubicon itself, which runs LPTs investing in assets in America, Europe and Japan, has had its own problems. “The rapid and unanticipated dislocation of credit markets globally has placed considerable pressure on the funding structure of RAT [Rubicon America Trust],” Rubicon announced on February 29. In particular, the collapse of the CRE CDO market (commercial real estate collateralised debt obligations) hit Rubicon hard, since its strategy had been to refinance its CRE warehouse facility through issuing a CDO.

Rubicon announced a series of plans to improve things, including the unwinding of FX hedges (which raised cash but exposes security holders to the Australian dollar/US dollar exchange rate), retaining all earnings to preserve cash, and selling up to A$800 million in assets. The resulting funds will be used to repay short term debt and then buy back securities; the aim is to bring the trust’s gearing to 55-65% (by contrast, an annual survey by BDO Kendalls found that the average gearing in LPTs across Australia was 41.1% in 2007). In March Rubicon struck a deal with Credit Suisse, the provider of the warehouse facility, to buy it more time for debt repayments and has gradually been selling assets, such as One Riverview Square in Miami, to keep the wolf from the door. The European and Japanese trusts have been going through similar steps.

In these cases the problem is not so much the overseas assets as the overall structure and debt load of the securities. For example, Rubicon’s European trust looked to be in good shape last August when it announced a 56% increase in first half net profit, and its portfolio of eight commercial properties in the Netherlands, Germany and Austria looked strong. But it also held a portfolio of property-backed mezzanine loans worth Eu 335 million at the time, and liquidity has drained from that market.

Other Australian trusts have suffered not so much from debt and structuring, but buying in to assets at what has since appeared to be the wrong time. Some portfolio managers in Europe raised their eyebrows at the activities of LPTs in the UK market over the course of the last year; Valad Property Group, which launched a A$1.1 billion UK Opportunity Fund in January and announced the acquisition of GBP80 million in UK assets the same month, is the one most commonly referred to here. “It went into the UK at the peak,” says one portfolio manager. Another is circumspect: “I don’t think there’s any doubt about the quality of origination, but the valuation they paid has come back on them.” In February Valad chairman Stephen Day pledged to sell non-core assets to reduce gearing; the manager has also been reducing its holding in a German fund. Elsewhere, Goodman Group, which also made UK acquisitions, has been reducing its exposure.

Some LPT backers have taken the approach of accepting they don’t know foreign markets well, so tying up with experts there. The best example of this is the Macquarie group, which has four LPTs in Australia alongside others in Singapore and Seoul. The Australian ones vary in their overseas exposure, from Macquarie DDR, which has 100% of its assets in US community shopping centres; to Macquarie Countrywide, which focuses on grocery-anchored shopping centres worldwide and has 62% of its assets in the US and 11% in Europe; Macquarie Office, with 51% in the US and 8% in Europe; and Macquarie Leisure Trust Group, which is chiefly domestic. Generally, Macquarie has partnered well with best of breed: brokers particularly like the partner in Countrywide, called Regency Centers, and DDR. Freedman calls Regency “one of the best in class in its field.” Fund managers tend to be less enthusiastic about Maguire Properties, with which Macquarie Office Trust has a joint venture; one manager calls it “problematic”.

Macquarie is an interesting group since it is arguably a pioneer in some of the financial engineering that has brought other trusts unstuck, but has emerged from the credit crunch in solid shape, apparently by seeing what was coming and acting accordingly. Macquarie DDR, the Macquarie trust that has attracted the greatest scrutiny about its sustainability, announced firmly and clearly early on that it planned to de-gear. “It’s about backing managers as much as it’s about backing assets,” says one analyst. “Macquarie’s come out clearly and said we need to sell assets, we’ve seen a change in the market coming and we need to respond to it as quickly as we can. That way we will be here in the long term.” This analyst contrasts that behaviour with ING Office Trust, which put in a capital hedge in December. “I’d argue that by then we knew that you get penalised, not rewarded, for doing that.”

He describes Macquarie as “the smartest guys in the shop. They’re the original pioneers with this stuff, but when other guys like Allco and Rubicon have tried the same thing they have come and gone very quickly. Macquarie’s guys not only worked it out first, they responded more quickly to it going wrong.”

The financial structuring that came with groups like Macquarie brings us back to the question of the risk profile of international expansion. “There’s no doubt that investing in different markets, whether they are non-traditional asset classes or offshore markets, adds a layer of risk,” says Freedman. “The question is how you manage that risk. Capital hedging can be categorised in one sense as managing the risk, but the reality is that some managers have done it more to boost yield than manage risk.”

For now, analysts are recommending stocks which, among other things, keep their exposure domestic. “Whilst we believe Australia would certainly not be immune to shocks around the globe, we are more concerned about the downside risk to LPT earnings across the US, UK and Europe should a material deterioration in economic conditions eventuate,” says Macquarie in a March report. “Thus we continue to remain attracted to the largely domestic exposures of [CFS Retail Property Trust, Commonwealth Property, Becton Property Group, Charter Hall Group and Stockland].” The two most highly exposed vehicles in Australia, with all of their assets derived from the US, are Tishman Speyer Office Fund and Macquarie DDR.

This is a separate point: whether the outlook for overseas property is worse than for assets in Australia. Clearly, the US is the big danger – the threat of recession started with its housing market, and there are big problems in finance in commercial real estate – and the UK real estate market has been falling since the fourth quarter of 2007. Australia, by contrast, looks robust economically so long as China keeps demanding its raw materials; it is one of the few countries in the world that is putting interest rates up, not down.

So when the dust settles on the credit crunch and LPTs start expanding again, will the days of buying overseas be gone? Certainly the equations governing offshore borrowing and yield might change, but nothing’s going to alter the fact that there just aren’t that many decent properties in Australia left to securitize. “Every REIT market is becoming more international, and everywhere in the world in equity markets there are companies listed on every major stock exchange that have investments offshore,” says Hiscock. “It’s just part of becoming a globalised marketplace. In the Australian share market many of the top companies have overseas investments and I don’t see this [the LPT sector] as any different. The only thing is, it’s critical to have on the ground expertise in the markets overseas in property. It’s just too easy to make a mistake otherwise.”