Where to from here for LPTs? - article supplied by Macquarie

The impact of sector consolidation

The LPT sector has been an investor favourite - Chart 1 gives you an idea why. Over the past ten years LPTs have outperformed the broader equities market, with an annualised 10 year return of 13%.  Equities delivered a 10.5% total return over the same period.  LPTs’ strong performance combined with the growing pool of superannuation funds has seen the sector grow considerably.  This maturity has forced the sector to evolve as fund managers seek higher earnings and larger platforms from which to explore offshore growth.  Consolidation has been the result.  Below we review the history of the sector and consider where to from here for LPTs.

History of LPT sector

 Source: Macquarie

Synopsis of the current climate
Understanding what the future might hold requires a look at the past.  In the past two years the LPT sector has been through a big growth phase. You can see in chart 2, the sector’s market capitalisation has grown to almost $70 billion with $20 billion added since 2002.  This has seen a large proportion of investment grade properties being bought by LPTs and other property funds (ie securitised).  In fact, Australian LPTs make up 8% of the world’s listed real estate assets and, as chart 3 shows, our property market is currently the most securitised in the world.  

 

No of trusts v's Property Index Market Cap
 

 

 Total Investor real estate v's % investment grade real estate listed

Source: Macquarie

 A number of factors have driven this trend, most notably the strong performance of LPTs relative to other asset classes and the growing volume of superannuation funds.  This environment has fostered innovation as fund managers search for new ways to deliver growth and performance to investors.

Impact: the LPT sector evolves
Over their 30 year history, LPTs have developed dynamically to enhance returns and meet investors’ needs.  The first LPTs invested only in Australian property and external parties were responsible for managing the assets.  Nowadays offshore investment is commonplace, and debt and foreign exchange management has become increasingly sophisticated.
More recently consolidation has been the name of the game, often creating property conglomerates with internal management structures.  Chart 2 shows this trend isn’t new.  By the end of the 90s, the first wave of consolidation began and the number of trusts shrank from 51 in 1999 to 37 in 2000, falling again to 34 in 2001.  Two trusts were introduced the following year, with the recent round of mergers and acquisitions causing that number to drop to 25.

 What is behind the consolidation?
 Consolidation is another way property fund managers can develop their trusts as they pursue earnings and distribution growth.
 Creating the property conglomerate
In the past, LPTs generally focused on deriving income from stabilised (ie developed and leased) commercial property.  Some of the successful and proposed mergers have seen a significant departure from this model.  The stapling of the property trust with the property manager has created internally managed trusts that undertake business activities.  The income from business activities such as development or construction is more risky than rental income from leased properties.  But in the right part of the cycle these activities can deliver additional earnings growth.
 Creating an offshore platform
 As we’ve already discussed, the level of institutional ownership of Australian property is high and the acquisition opportunities at home are limited. To continue to grow many trusts are seeking acquisition opportunities outside Australia.  Consolidation is providing larger platforms to enhance efficiencies when dealing offshore.  Some of the recent merger activity delivered a significant increase in US exposure and opened up future opportunities to buy assets in North America. 
 The advantage of size
Bigger companies with bigger balance sheets can access more favourably-priced capital.  This is important when a trust is buying properties because it determines whether the acquisition will increase its earnings.  This is called ‘earnings accretion’ in the property business and it occurs when the property yield (income) is greater than the cost of capital (ie what yield you have to pay the market for them to give you capital to purchase the asset). 
 
What are the potential risks of consolidation?
Higher exposure to riskier non-rental income
UBS estimates that in June 2000, approximately 96% of the sector’s earnings were derived from rental income.  This number will be around 87% after the recent round of activity and proposed mergers go ahead.  This is still high and suggests that resilient income from LPTs is available. 
That being said, higher development, construction and residential earnings are now an emerging component of the sector.  This type of income is generally riskier because it’s subject to the vagaries of the development cycle without the certainty of lease contracts and quality tenants.
Macquarie’s property trusts maintain their focus on buying properties that are already developed with high occupancy levels or redeveloping properties for longer term ownership.  This long term view means Macquarie’s trusts’ returns are less exposed to development cycles.  Importantly, these development projects are largely commissioned to suit our tenants’ requirements and so have an excellent track record of increasing the income derived from the asset.
Increased offshore exposure
Most of the mergers have increased exposures to overseas markets (specifically the US), which investors are less familiar with.  Investing offshore does have additional risks but we believe astute management mitigates those risks and typically the net result can be positive for investors. 
Increased gearing
Offshore investing has driven higher gearing levels as trusts take advantage of lower interest rates in the US while minimising tax leakage.  These higher debt levels can increase the risk to investors while also increasing potential returns.  It highlights the importance of conservative interest rate risk management strategies (like fixing interest rates) and innovative debt structuring (like Commercial Mortgage Backed Securities).

The future
The LPT sector has delivered some of the best returns to investors over an impressive history.  Strong fundamentals point to continued performance - the Australian economy is robust, global markets are recovering and interest rates are low worldwide.  In fact, Macquarie Research Equities forecast an average sector yield of 6.9% for 2005 and this number doesn't include any capital appreciation investors could potentially enjoy.
At the same time, competition for properties and a strong inflow of funds into the LPT sector is forecast to continue.  Offshore markets are anticipated to supplement the lack of Australian opportunities.  The US will remain a key target market while Europe and Asia will have greater focus. 
We believe that consolidation is not over and you can expect to see more mergers and takeovers in the future.  At the same time, you should see some new floats investing in new markets and new property classes.
So despite some of the challenges arising from sector consolidation, LPTs are still expected to deliver a regular and growing income stream.  The difference is, some will be more secure than others.

This information has been prepared by Macquarie CountryWide Management Limited, Macquarie Office Management Limited, Macquarie ProLogis Management Limited, Macquarie DDR Management Limited, and Macquarie Leisure Management Limited (together the 'Companies'), and in preparing this information, the Companies have not taken account of any person's objectives, financial situation or needs and because of that, you should, before acting on this information consider the appropriateness of the information having regard to your own objectives, financial situation and needs.

Units in the Macquarie CountryWide Trust (MCW) are issued by Macquarie CountryWide Management Limited (MCML) ABN 46 069 709 468.  A Product Disclosure Statement (PDS) for the renounceable rights offer in respect of MCW has been sent to unitholders. To obtain a copy of the PDS , call the Rights Offer Information Line on 1300 365 585 (local call cost). Potential investors should consider the MCW PDS when deciding whether to take up the offer.

Units in the Macquarie ProLogis Income Trust (MPIT) are offered by Macquarie ProLogis Management Limited (MPML) ABN 94 100 226 293.  A PDS dated 23 February 2005 and a Supplementary PDS dated 28 February 2005 for  MPIT have been lodged with the Australian Securities and Investments Commission, and will be made available at the end of the exposure period for the PDS. To obtain a copy of the PDS, call the MPIT Offer Information Line on 1300 303 063. Potential investors should consider the MPIT PDS when deciding whether to invest in MPIT.

Each Company is entitled to receive fees for operating the property trusts that they manage, which are calculated by reference to the value of the assets of the relevant trust and according to that trust's performance.  Entities within the Macquarie Bank Group may also receive fees for managing the assets of, and providing resources to the trusts.  For more details on fees, review the trust's latest annual report, the MCW PDS or the MPIT PDS.

Past performance is not a reliable indicator of future performance.  Due care and attention has been exercised in the preparation of forecast information, however, forecasts by their very nature are subject to uncertainty and contingencies, many of which are outside the control of the Companies and actual results may vary from forecasts provided.

Investments in any trust are not deposits with or liabilities of Macquarie Bank Limited (ABN 46 008 583 542), the Companies, nor any Macquarie Bank Group company and are subject to investment risk including possible delays in repayment and loss of income and principal invested.  None of Macquarie Bank Limited, the Companies or any other Macquarie Bank Group company guarantees the performance of the trust or the repayment of capital from the trust.