What should we expect this reporting season?

The S&P/ASX 200 A-REIT Index has delivered total annual returns of 7.3%, 14.6% and 15.0% over the past 12 months, 3 years and 5 years respectively^. In doing so, it has comfortably outperformed both the All Ordinaries and S&P/ASX 200 indices over the same time frames. Incredibly, the A-REIT Index outperformed the broader equity market by 6.5% in January alone, as global growth fears placed considerable pressure on equity prices.
This begs the question: where to now for property? Firstly, given their role in the pricing of assets, it is useful to review trends in global bond yields and interest rates. Despite the hysteria surrounding the US lifting interest rates for the first time in years, rates remain at historically low levels across the globe. We continue to view this as a protracted and grinding cycle: one that provides a degree of support for good quality, high yielding assets.
The above thinking was recently thrust to the forefront of investors’ minds following the Bank of Japan’s (BoJ) shock announcement that it will move interest rates into negative territory. Specifically, the bank announced that it will charge an interest rate of -0.1% for excess reserves parked at the BoJ by financial institutions.
The announcement reverberated across markets swiftly, with yields on Japan’s 10 year bonds crunching to fractional levels. While more stark, this merely reflects recent trends in most major government bond yields. With stalling growth numbers adding to fears already permeating throughout equity markets, bonds have rallied strongly over the past 3 to 6 months (note: as bond prices rise, bond yields fall).

Figure 1: Japan Government 10 Year Bond Yield, Nov 2015 – Jan 2016
Source: Trading Economics, Japan Department of Treasury
 
As a consequence, a plethora of global buyers armed with masses of liquidity and funded by a world of cheap debt, are on the hunt for income backed by quality assets. Such buyers are buying property assets on increasingly tighter yields.
This is leading to a compression of capitalisation rates in listed A-REITs. The capitalisation rate, often called the “cap rate”, is the ratio of net operating income to property asset value. As the cap rate compresses, asset values increase. Including a very basic example will hopefully illustrate what is currently occurring in the property sector:
An investor buys a property delivering $10 of net income per annum for $100 (at a cap rate of 10%). The property has embedded income growth of 3% per annum and the cap rate subsequently compresses to 9.5%. What is the reported result?

Figure 2: Property Example
 
As outlined in the above table, the property has delivered a statutory result of $18.72 to the investor, comprised of $10.30 of operating profit and $8.42 of asset revaluations.
This has been a feature of the A-REIT sector in recent years, one we expect to continue in the upcoming reporting season. Already, we have seen no less than 6 property trusts pre-report increases in asset values off the back of tighter cap rates (highlighted below).

Figure 3: Cap Rates for Sample of AREITs, FY2014 – 1H2016
Source: ASX filings; ARF, BWP, CMA, SCP, SGP, VCX.
 
A word of warning for the uninitiated: while we view this as a slow, grinding cycle that is generally supportive of property, cap rates cannot and will not compress forever. How much of the increase in asset valuations are actually driven by fundamentals, such as increased occupancy and operating income, are key questions for the upcoming reporting season. As such, we remain focused on paying sensible prices for property groups that generally rate well across the following metrics (also noting the trends of each):

  • High and increasing levels of occupancy
  • Long dated weighted average lease expiries (WALE)
  • Solid level of real rent growth and contracted embedded rental growth
  • Preference for low to moderate gearing
  • Low weighted average cost of debt (WACD)
  • Solid or better distribution yields
  • Price to NTA (note this factor needs to consider funds management and development activity, if any).

While the property groups themselves have attracted greater levels of investor interest of late, in our view much of the tailwinds supporting the sector have been somewhat priced in. We therefore believe that some of the smaller property focused asset managers perhaps offer better value (although risk profiles differ).
Three that we have identified are APN Property Group (ASX:APD), Elanor Investors Group (ASX:ENN) and Folkestone Limited (ASX:FLK). These companies are growing, pay solid dividends (distributions in the case of ENN), typically co-invest in the funds they manage and are guided by experienced management teams that are substantial equity holders themselves. We briefly profile each below.

Emerging Asset Management Companies

APN Property Group (APD) is a specialist real estate investment manager with approximately $2.2bn of listed and unlisted assets under management. APD has enjoyed considerable FUM inflows into its flagship APN A-REIT Fund while its listed A-REITs, Generation Healthcare (GHC) and Industria (IDR), solidly outperformed broader property and market indices in the first half. As a result, we expect APD to benefit from mark to market gains in its direct holdings, achieve performance fees and deliver sound growth in operating income in FY16.

Figure 4: APD FUM, Profit and Share Price, FY13 – FY15
Source: APN Property Group AGM Presentation, Nov 2015
 
Elanor Investors Group (ENN) listed on the ASX in mid-2014 and has made an impressive start to life as a listed entity. The security price has rallied solidly from its initial offer price of $1.25 at IPO, reflecting successful execution of the Group’s numerous growth initiatives since.
The Group has three core operating divisions: Hotels, Tourism and Leisure; Funds Management and Special Situation Investments. ENN’s hotels, tourism and leisure division is largely comprised of direct ownership of assets such as Peppers Cradle Mountain, Featherdale Wildlife Park and Mantra Wollongong. Given the growing tailwinds supporting Australian tourism, we remain positive on the prospects for this division in the years ahead.
ENN also appears to be gaining operational momentum in its funds management business, which encompassed nearly $350m of funds under management as at June 2015. ENN typically generates revenue via an acquisition fee upon settlement of any new assets followed by annuity-like management fees thereafter.

Figure 5: ENN FUM and Direct Investments as at 30 June, 2015
Source: Elanor Investors FY15 Results Presentation, Aug 2015
 
In terms of the outlook, management recently commented “Based on the current operating performance of its assets and pipeline of potential funds management opportunities, ENN anticipates continued growth in Core Earnings in FY16.” Given the Group has a high quality management team, sound future prospects and a yield of about 8.2% (unfranked), we believe ENN is worthy of consideration for those seeking a mix of growth and income.
Folkestone Limited (FLK) is a real estate funds management and development company. Like its peers, FLK manages and co-invests in a range of listed and unlisted funds. With that noted, more than two thirds of its funds under management (FUM) is comprised of assets that sit within listed A-REIT Folkestone Education Trust (FET). Greater amounts of capital have been flowing to sub-sectors such as childcare, healthcare and seniors living in recent years. As manager of the $655m (assets under management) childcare-focused FET, FLK continues to be a beneficiary of this theme.


Figure 6: ELC Sale Yields, FLK Balance sheet Assets and FUM as at 20 June 2015
Source: ABS, Folkestone Limited
 
As is obvious from the above chart, FLK’s direct stake in FET represents a sizeable proportion of balance sheet assets. In fact, at current market prices, this stake accounts for greater than 50% of FLK’s market capitalisation. Following the recent pullback in its share price, FLK now trades at a discount to equity, which suggests value is starting to appear.
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Figure 7: APD, FLK and ENN Valuations and Forecast Dividend Yields
Source: Stocksinvalue.com.au

 
The following research was written by Adrian Ezquerro, Senior Analyst.
Clime Asset Management owns shares in APD, ARF, ENN, FET, SGP and VCX on behalf of various mandates where it acts as an investment manager. Adrian Ezquerro owns shares in APD.
^Performance timeframes to 31 January 2016. Prices & valuations cited correct at time of writing, 4 February, 2016.