Commercial sector not without its risks - 5th June 2003
Robert Harley - Australian Financial Review
In the Queensland city of Mackay, the National Australia Bank has taken possession of a small commercial office building in Wood Street.
The holding, part of the Landmark Property Syndicates operation that was wound up last year, will be sold through Ray White Commercial.
But with one of the two tenants about to vacate, investors in the syndicate will struggle to get their money back.
Property is flavour of the season. Money is flooding into the sector and every day brings a new high for a trust, a record price for a shopping centre or a development site.
But commercial real estate is not without its risks. Investment structures collapse, tenants walk out, economic conditions change and builders fail to complete. A number of analysts are beginning to question whether, in the present enthusiasm, the risks are being priced correctly.
In the last week, the top end of town has discovered some basic property risk. Weak tenant demand, and the need to spend money upgrading buildings, has forced both the $1.3 billion Deutsche Office Trust and the $1 billion Macquarie Office Trust to forecast lower earnings next year.
And SARS, Iraq and the rising Australian dollar have so affected hotel revenue that the $360 million Thakral Holdings Group and the $110 million Grand Hotel Group have dropped their forecasts for the current year.
In the case of Grand, the final payout has been cut altogether.
At the same time other trust stocks, particularly those with retail holdings, or residential development earnings or a takeover premium, have been surging - well beyond asset backing.
Two weeks ago, Andrew Parsons, the head of Lend Lease's real estate securities, warned that property trusts had never been riskier.
Risk, says Bob Kelly, the head of funds management at Colonial First State Property, is the "key issue for the listed property trusts".
"The LPT market was founded to provide investors with a conservative, property/lease backed income stream, which was a defensive stock."
"The market is now departing significantly from these traditional roots and the risk profile of the market has increased in all kinds of ways through development driven stocks, increased gearing, and offshore investments as well as some more exotic structures. Elements of risk in some cases are not properly disclosed and are certainly in many cases not well understood or analysed by the market."
Kelly says the trust stocks with the greatest risk - typically those with returns enhanced by development or other business income - are now trading on the lowest yield.
"This is the inverse of what we intuitively know to be true; that there must be an appropriate premium for the risks taken," he said.
It happens because investors start assuming that development profits can be projected long term - which, according to Kelly, is just as unsustainable now as it was in the late 1980s.
Takeover mania then transfers that premium across the sector to create a "pricing bubble".
"Mispricing of risk, and movements towards increased gearing and risk-taking activity in the LPT sector is sowing the seeds of a potentially large fall in this market," Kelly says.
Bill Moss, the head of Macquarie Bank's Banking and Property Group believes another sort of risk, construction risk, is also being mispriced, particularly when building costs are rising steeply.
Moss saw the carnage of the mid '70s and early '90s.
"We know builders collapse and people go under," Moss says. "I can remember clearly when it cost as much to finish the last 20 per cent as the first 80 per cent."
"We have narrowed the risk premium on delivery so that today the risk is not being correctly priced."
"There should be a greater differential between those vehicles which have development and those that don't."
Moss supplied today's graph, which points to a key question for all property trust investors - in fact for all those who buy commercial real estate. In general, the trusts have had a great decade-long run. But as the graph shows, the run is very closely correlated with a decade long fall in interest rates.
Can we expect the same sort of growth, now that rates, particularly in the US, can hardly go any lower