Does opportunity knock at the door of listed property?

As I am sure is the case for all of us who have lived overseas, I learned some valuable lessons and benefited from some lucky breaks while I worked in...

As I am sure is the case for all of us who have lived overseas, I learned some valuable lessons and benefited from some lucky breaks while I worked in London on the Australian desk with a well-known stockbroker.

One of my early lucky breaks came back in 1999 when, being the junior, I was rostered to work on the first bank holiday Monday in May.  It was rather tedious given the City was empty and it was night time in Asia and Australia so the markets weren’t trading.  However at 5pm the phone rung and I received an order from a funds manager in Germany to purchase $20 million of BHP shares on the ASX when the market opened later that night.  At the time, that was a significant order and I was well pleased.  It turned out I was the only Australian broker working in the City that day, so I received the order!  My second lucky break taught me a valuable lesson in customer service.  I was in my hotel room one evening in Zürich and I turned the TV onto Sky News to kill some time.  There was a breaking news item with pictures of Sir Richard Branson leaning out of the cockpit window of a 747 announcing that Virgin Atlantic was about to start a service from London to Sydney, challenging the hitherto dominant (and very profitable) position of Qantas.  A client that I had been wooing and had yet to trade with us mentioned in one of our meetings that the only position he held in Australia was in Qantas.  Even though it was 11 pm I decided to give him a call because Virgin’s entry into the market would not be good for the Qantas share price.  In spite of the hour, the client was exceedingly grateful that I had given him this news, though it was bad, and he rewarded me with an order to sell $50 million of Qantas shares.  Over the next few weeks we sold all $150 million of his fund’s Qantas shares and I was congratulated by my boss for introducing that new client to our operation.

One more serious lesson I did learn though concerns property and more importantly property shares.  One of my clients was the Far East real estate funds manager for a substantial Netherlands pension fund.  It was a very large organisation back then but I didn’t really realise just how large until one Friday afternoon.  I received a call from my client advising that his fund would like to buy some Westfield Trust shares in Australia.  (Back then Westfield Trust was the listed real estate investment trust which owned all the Westfield retail shopping centres throughout Australia and New Zealand.  The centres and their tenants were managed by related company, Westfield Holdings.)  He explained to me that he had been waiting for years for the right time to make this purchase and that the  time was now given the share price was uncharacteristically trading at a discount to the Trust’s net asset backing.  He further explained that this effectively meant that he could buy the buildings, the “bricks and mortar”, for cheaper than they were either worth and cheaper than their replacement cost.  It was a fruitful conversation during which I learnt about property stocks, their pricing and their return characteristics.  My client was particularly excited at the opportunity as he was looking to allocate up to $1 billion into Australian listed property trusts if the pricing remained attractive. Lucky me!

Which leads me on to the main topic:  the property stocks listed on the NZX and their current pricing.  We hosted a presentation last week at which one of the speakers was the CEO of Kiwi Property Group (the former Kiwi Income Property Trust).  He provided an update of the company’s property portfolio, its tenancies and tenant mix and importantly the trading of its major retail operations:  all rather healthy, especially the 99.8% current occupancy rate.  He further outlined long term development opportunities at Sylvia Park and out at Drury in particular.  Again, all rather healthy.  At the end of his presentation he showed a chart of the share price over the past couple of years as well as some key investment metrics, namely dividend yield (always important for property stocks), asset backing and debt levels.  To me these, once again, all looked rather healthy:  a pre-tax gross dividend yield of almost 10% expected this year, debt to total assets of 31.6% so not overly geared and, here’s the most important metric, price to net tangible assets (P/NTA) of 0.67x.  The P/NTA measure indicates that the share market is valuing the company and its assets net of debt at 33% discount to their underlying value.  So what you might ask?  Well, listed companies trade at a “discount” to their underlying value all the time but in my view property companies are different.  For example, Apple shares theoretically trade at a value reflecting the future cash flows the market expects the company to generate based on selling new iPhones and iPads, Apple Watches etc. and ancillary related services.  It’s somewhat subjective but that’s how markets work.  Although discounted expected future cash flows also drive the share price performance of listed property companies their underlying “bricks and mortar” valuations surely must underpin the company’s share price?  If it cost $10 million to construct a building why would it trade at, say, $7 million.  So, this presentation last week made me look at the whole NZ listed property sector.

The inflation spectre and associated increases in interest rates are causing share markets to fall all round the world and “all things listed” are seemingly suffering the same fate.  The listed property sector here in NZ has fared worse than the overall market during this period of sell-off as the rising interest rates have led to property valuations being reassessed as well as potential tenancy and therefore income risk.  The sector fell 12% in the June quarter, 2% in the September quarter and is down a little more than 3% so far in the current period.  This is approximately 10% worse than the broader share market over the same period.  Let’s look at some fundamentals:  the net dividend yield forecast for the sector is a reasonable 4.6%.  Earnings forecasts for the next couple of years have come down a touch recently (as interest costs bite into profits) but only by single figures.  Gearing levels remain modest at an average of 30% across the sector.  P/NTA averages 0.73, that is the value of the companies implied by their share prices is 27% less than what the net assets of those companies are valued at.  Sure, there’s always some valuation risk from potential changes in tenant income and interest rates but close to 30% discount appears to be quite a lot.  In fact back in 2008 – 2009 in the midst of the GFC, this discount peaked at 32%, so current pricing looks to be factoring in an outlook and uncertainty as dire as that prevailing in and around that time.

And therein lies the potential opportunity:  has the baby been thrown out with the bathwater and are our listed property stocks being mis-priced and viewed the same or even worse than the broader share market?  Maybe, this substantial discount is excessive given the fundamentals I mention earlier.  At least one stockbroker analyst has similar thoughts recently commenting that growth prospects for the sector, asset quality and dividend outlook all look good at present.

I wonder what my old colleague who looked after the pension fund in the Netherlands – incidentally now a fund size of some Euro 230 billion – would be thinking today were he to be looking at these NZ properties trading at prices so significantly below their asset backing and / or replacement values?