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5 top tips for picking the best property play

Photo of Stephen Hiscock By Stephen Hiscock

min read

What to look for in a promising Australian Real Estate Investment Trust.

Stephen Hiscock is Managing Director of SG Hiscock & Company, a boutique fund manager specialising in Australian equities and real estate, with approximately $2.3 billion in funds under management.
We asked Stephen what his top five factors are when reviewing the Australian Real Estate Investment trusts listed on ASX. Here is what he had to say:
Although a combination of factors are used in our approach, these are the five most important:

  1. Valuation.
  2. Outlook for the relevant property sector.
  3. Gearing.
  4. Quality of portfolio.
  5. Quality of management team.

Let’s look at each in more detail.
1. Valuation
The first step and the bedrock is valuation. There is no point buying an AREIT with a strong fundamental outlook if it is materially overvalued. To assess valuation we use a combination of the following:

  • Discounted cash flow valuation of the forecast free cash flow generated by the AREIT going forward, after accounting for tenant incentives and maintenance capital expenditure.
  • Net asset valuation (NAV), which is a “sum of the parts” valuation of the property portfolio, as well as any other businesses such as funds management and development.
  • Implied capitalisation rate (the expected rate of return on the property).

It is essential when assessing the valuation of an AREIT to not just use the stated net tangible assets per share (NTA) as the metric. The stated NTA is set by valuers. It is generally a lagging indicator, as property valuers must use actual market sales evidence in their assessment.

In addition, many AREITs have other businesses as well as their tangible property assets, and these also need to be accounted for in the valuation.

Just using valuation, in isolation, to identify investments, does not guarantee excess returns. We have often seen a security that appears undervalued but it continues to underperform because its fundamental factors, such as debt levels, are so poor.

During the GFC many securities were “cheap”, but because they had such high levels of debt, their security performance continued to deteriorate despite being undervalued. In some cases they were forced to recapitalise their balance sheets (raise more funds) to such an extent that unitholders never recovered all their money, and thus the undervaluation was permanently lost.

In terms of assessing the fundamental outlook, we use 26 factors, both macroeconomic and microeconomic, that is, specific to the AREIT.

2. Outlook for the relevant property sector
We need to look at the outlook from both a macro level (from retail, office, industrial, residential) and sub-sector/regional level. For example, if we use the office sector as a case in point, there are broad factors that will affect the market nationally, such as business confidence, economic growth and white-collar employment growth.

Regional factors include the amount of new office space being built, withdrawals from the office stock (conversion into apartments) and the relative attractiveness of rents in the CBD versus the suburbs.

3. Level of debt
The age-old question is, what is the appropriate level of debt for an AREIT over a full property cycle? The answer will fluctuate depending on factors such as the direction and level of interest rates, asset pricing, diversification, lease profile, and quality of the tenants and the portfolio.

In general though, an appropriate level of debt will ensure that at no stage in the property cycle will the AREIT become a forced seller of property, nor be forced to go to the equity investors to raise capital in a way that dilutes shareholder equity, as happened during the GFC.

Some AREITs (for example, with high-quality portfolios and long leases to high-quality tenants) can afford to have a slightly higher level of debt than others (those with short leases, fewer or lower-quality tenants, or with major looming capital expenditure).

As a broad generalisation, for a properly diversified AREIT portfolio with high-quality assets, such as GPT or Dexus, we believe approximately 25 to 30 per cent debt as a percentage of total tangible assets is appropriate level over a full cycle.

4. Quality of property portfolio
A high-quality portfolio is ideally what an investor should look for. It will stand the test of time. Higher-quality properties often offer a number of features:

  • They tend to attract more tenant demand.
  • They can charge higher rents and have higher rent growth.
  • They pay less incentives to lure prospective tenants.
  • The downtime (foregone rent) between tenants should be less.
  • They tend to dominate their catchment area, which reinforces the need for tenants to be represented in that asset. In retail, Chadstone in Victoria and Bondi Junction in NSW are two good examples of this.
  • They can be less capital intensive and more energy efficient.

5. Quality of management team
Generally the quality of management across the AREIT sector is high, and boards are more actively engaged with investors, which further promotes alignment of interest. The AREIT sector, by virtue of its size, can afford to pay attractive salaries to attract the best and most experienced property people, and compensation packages are increasingly focused on long-term goals rather than short-term share price moves.

We look at a number of factors to assess quality of management, including experience, but it is also important to assess the quality at all levels of management, including the asset management team, the development team, and other senior management people.

Staff turnover is a factor, as is staff satisfaction. It makes a difference, especially in property classes that are management intensive, where a great leasing team over the longer term can bring greater success, with lower vacancies, less incentives and higher rents than a less-experienced team.

There are less tangible positives as well. A high-quality team will look after unitholders over the longer term and do what’s best for them over the next five to 10 years, not just over the next 12 months. Although it might be sorely tempting to pay the highest possible distribution out in any given year, is that really the best thing to do over the longer term if that forces an AREIT to raise debt or equity later on?

About the author

Stephen Hiscock is Managing Director of SG Hiscock & Company, a boutique fund manager specialising in Australian equities and real estate, with approximately $2.3 billion in funds under management. He jointly manages the AREIT portfolios with Grant Berry.

From ASX

SG Hiscock & Company is a foundation member of the ASX mFund Settlement Service. The mFund Settlement Service enables you to buy and sell units in selected unlisted managed funds directly with the mFund issuer via a stockbroker or advisory services used to transact shares or other ASX products.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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