Taking Stock 29 June 2023
Fraser Hunter writes:
New Zealanders have a well-known love for property investment, a sentiment that is deeply ingrained in our culture and has significant implications for our economy. As per a 2022 whitepaper by the Reserve Bank of New Zealand (RBNZ), housing accounts for nearly 57% of household assets. This figure is almost twice the combined value of equity, bonds, and investment fund assets, which stands at 30%.
The substantial wealth generated over the past 30 years (an average of 6.9% per annum) and the benefits associated with home ownership are key factors driving this high exposure to property. This sector's importance is further underscored by the extensive media coverage it receives.
Recently, the RBNZ signalled the end of its rate-raising cycle, sparking renewed optimism and interest in the property sector. Given this and the recent release of results from several key listed property companies, it seems an opportune time to provide a review of the listed property sector.
Importance of the property sector
The property industry is a cornerstone of New Zealand's economy, contributing significantly to the nation's Gross Domestic Product (GDP). According to the NZ 2021 Property Industry Impact Report, the industry it accounts for 15% of total GDP, with a direct economic impact of $41.2 billion. The industry also indirectly contributes $31.8 billion to GDP and induces an economic impact of $42.5 billion.
The report also places the property sector as the country’s fourth-largest employer, accounting for 9% of total employment. A large proportion of this falls under the construction services sub-sector, which employs 48% of all workers in the property sector.
For investors, the property industry also plays a key role in the financial markets, representing nearly 10% of the NZX50, with a market cap of more than $12 billion. KiwiSaver funds have an allocation of between 2.4% and 8% to the property sector (NZ and Global), underpinning its value and importance to investment portfolios.
Why invest in property?
While many investors already have significant exposure to property through their homes and rental properties, there is still value in considering additional exposure via the listed property sector.
New Zealand's property sector is characterised by its defensive nature, with a large portion of the market focused on collecting rent and paying dividends. This stands in contrast to the global Real Estate Investment Trust (REIT) industry, which tends to be more aggressive, with a focus on developers, syndicators, and managers. As a result, New Zealand's property sector often trades closer to asset values, leading to more predictable investor returns, which are typically a combination of growth in asset values and dividends.
Investing in the property sector offers several benefits, including a steady income stream, potential for capital growth, and diversification of returns. Over the past three years, property has shown little correlation with bonds and a loose correlation with the NZX 50. This trend aligns with historical performance and suggests that adding property exposure to a portfolio of bonds and shares can help reduce risk and potentially enhance overall portfolio returns.
In recent times, the property sector has seen lacklustre performance, with a modest year-to-date return of 3.1% (inclusive of dividends) and a decrease of 3.1% over the past year. Over the last five years, the sector has yielded an average annual gross return of 3.9%. This compares to the benchmark NZX50, which returned 6.4%, and the investment-grade bond index, which has returned 0.6% per annum.
These recent figures are notably lower than historical trends and expectations, highlighting the challenging investment environment recently. Before the disruption caused by the COVID-19 pandemic, the property sector had delivered annual returns of 9.6% since 2006, even considering the impacts of the GFC. It's important to note that these past returns were lifted by the long-term trend of declining interest rates, which elevated asset values. While it remains to be seen whether this trend will continue, it is unlikely that rates will return to the near-zero or negative interest rates the RBNZ had been considering the in the past.
May company results
In May, six property companies reported full-year results, which were generally in line with market expectations. Despite stable tenant demand driving solid operational outcomes, higher interest costs have cast a shadow on the outlook for earnings and distributions. The softening of capitalisation rates (rental yields), falling asset values, and committed development spend have resulted in increased sector gearing.
New development commitments were minimal, and most of the companies are investigating capital management initiatives, typically involving asset sales and/or dividend reinvestment, to strengthen balance sheets. Despite share prices implying a further fall, property book valuations continued to decrease but at a slower pace.
The announcements from Goodman Property Trust (GMT) and Asset Plus (APL) stood out, with GMT's solid performance and APL's potential for a capital return drawing attention. However, the sector faces challenges with higher interest costs and increased gearing affecting earnings growth, as seen with Argosy (ARG) and Investore (IPL). Kiwi Property Group (KPG) and Stride Property (SPG) also reported solid results, but their growth outlooks are constrained by factors like asset recycling and higher debt costs.
Understanding the Composition of the Listed Property Sector
The New Zealand listed property sector comprises 12 companies, with eight of them of meaningful size. Goodman Property Trust leads the pack with a market capitalisation exceeding $3 billion. Following closely are Precinct with a market cap of $1.9 billion, Vital Healthcare at $1.5 billion, Kiwi Property Group at $1.4 billion, Argosy at $0.9 billion, Stride at $0.7 billion, and Investore at $0.5 billion. The sector is further diversified by smaller companies such as Winton (WIN), Asset Plus (APL), CDL Investments (CDI), and NZ Rural Land (NZL).
Sector Exposures: Industrial Property Sector
The industrial sector is a key component of the property market, with Goodman (GMT) and Property for Industry (PFI) being the primary players, with Argosy (ARG) a diversified property owner, with the majority of its portfolio Industrial.
Both PFI and GMT have a strong history of growth and have expanded their portfolios and dividends since the Global Financial Crisis. Goodman has focused on developing greenfield sites, while PFI's growth strategy is primarily driven by acquisitions and expansions, complemented by the strategic disposal of non-core assets.
GMT is a prominent developer and manager of industrial properties, with a $4.8 billion portfolio concentrated in Auckland. GMT's properties, comprising strategically located business parks and industrial estates, cater to the growing demand for urban logistics space. These assets support a range of tenants, from small businesses to multinational corporations. GMT's commitment to sustainability is reflected in their energy-efficient designs and green building practices. In addition to property development, GMT offers comprehensive services including leasing, property and facilities management, and project development, solidifying its position as a leading player in New Zealand's industrial property sector.
PFI is a key player in New Zealand's industrial property market, with a focus on the Auckland region, which accounts for 83% of its portfolio. PFI's diverse portfolio includes 85 individual properties, with no single property representing more than 7% of annual rental income. This diversification strategy extends to its tenant base, with multiple properties leased to key tenants such as Fletchers, EBOS, and Move Logistics.
ARG maintains a diverse investment portfolio of approximately 100 properties, with a focus on industrial (53%), office (38%), and large format retail (9%) buildings. The majority of ARG's properties are located in Auckland (70%) and Wellington (27%). ARG's strategy involves the acquisition of properties with potential for improvement and development into core assets, replacing non-core assets in the process. This approach has allowed ARG to build a robust and diverse portfolio that caters to a wide range of tenant needs.
The industrial sector has consistently performed well, supported by factors such as the growing importance of logistical networks, the shift towards online consumer and business behaviour, and increasing import and export volumes. This success has led to a premium trading position for the sector, particularly for GMT and PFI, reflected in their higher P/E ratios, lower discounts to book value, and lower yields.
Retail Property Sector
The retail property sector is dominated by Kiwi Property Group (KPG) and Investore (IPL), each offering unique retail property exposures.
KPG's portfolio is primarily composed of retail and mixed-use properties, including some of New Zealand's most prominent shopping malls and associated facilities, as well as key office buildings in Auckland and Wellington. The global outlook for malls has been impacted by the rise of online shopping and the effects of COVID-19, prompting KPG to shift its strategy towards creating lifestyle communities that incorporate shopping, business centres, hospitality, and apartments. A key part of this strategy is the development of a town centre on its Drury site, a long-term project that will transform 51 hectares of farmland into a vibrant community. While the timeline for this project spans decades, it represents a significant part of KPG's future growth, potential success, and capital requirements.
IPL, on the other hand, focuses on large-format retail property assets, typically an anchor major tenant (i.e., a supermarket) and surrounding retail and parking. IPL's portfolio is heavily reliant on Countdown, which accounts for over 60% of portfolio income. This relationship provides some certainty around leasing and tenant quality. IPL's properties are geographically diverse, with over 40 properties spread across the country.
The outlook for the retail sector is mixed, with rents and occupancy rates tied to retail sales, which can be vulnerable in a recession. However, KPG trades at one of the highest discounts to asset backing in the sector, suggesting a potential further significant fall in property values. Despite the risks, KPG stands to benefit from long-term population growth in the Auckland region, which should underpin future success. Long-term development projects have proven successful in other regions and can weather most business cycles due to their ability to adjust development speed based on demand.
Healthcare Property Sector
The property healthcare sector consists of just one company, Vital Healthcare Property Trust (VHP). VHP specialises in acquiring, developing, and managing high-quality, well-tenanted properties in the healthcare sector across New Zealand and Australia. The portfolio is diverse and consists of 47 properties including hospitals, out-patient facilities, aged care facilities, and research facilities.
Due to its needs-based nature, VHP has a high occupancy rate (98.4%) and longer lease terms (average expiry 17.2 years) than the rest of the sector. VHP has a strong history of delivering investor returns through steady growth in asset values and the ability to increase rents. While VHP's exposure to the healthcare sector positions it for continued earnings and dividend growth, its main risk lies in its valuation, as it trades at a higher P/E than the sector, has a lower rental yield, and relatively high gearing.
Office Property Sector
The office property sector is primarily represented by Precinct (PCT) and Stride (SPG). PCT specialises in building and managing prime office buildings in Wellington and Auckland, with recent developments focusing on properties on the Auckland waterfront and the Wellington Government Precinct. PCT has also announced a partnership with Singapore investment fund GIC to buy and manage further prime properties.
SPG, on the other hand, offers a more diversified exposure, with 65% exposure to office and the remainder to retail. SPG is a stapled security consisting of Stride Property Limited and Stride Investment Management Limited. SPG's growth strategy is centred around growing its investment management business, making its growth outlook more uncertain than the rest of the sector.
The office sector is heavily exposed to economic cycles, which can quickly impact demand and revenues for their properties. As a result, the sector has the shortest leases, the most churn in tenants, and therefore the most risk of vacancy. Success in this sector is reliant on a manager’s ability to attract and retain key tenants. PCT mitigates part of this risk by purchasing and developing prime properties, attracting flagship tenants for long leases to secure unique properties that appeal to staff and clients.
What has been going on internationally?
The global commercial real estate market is facing some serious challenges as investors and lenders struggle with the changing dynamics of work, shopping, and living brought about by the pandemic. Cheap debt fuelled a buying spree in the sector, but now owners are walking away from debt rather than investing more money. In the US alone, around $1.4 trillion of commercial real estate loans are due this year and next. Major institutional owners such as Blackstone, Brookfield, and Pimco have already stopped payments on properties, recognising the dire situation.
Transaction activity has dried up and prices have plummeted as a result. US office values are down -27% and even greater declines are expected in Europe and Asia. This is adding stress to a financial system already under pressure and will also have an impact on some major cities that are reliant on properties for tax revenue. A prolonged downturn in the commercial property market has the potential to destabilise the wider economy.
In terms of debt issuance across the property sector, the biggest issuers are GMT, KPG and PCT. GMT ($100m) and KPG ($125m) have bonds maturing later in the year. Both were issued at a 4% yield which, based on current rates, could potentially be re re-issued above 7%. GMT, KPG, PCT, IPL & PFI all have bond issues maturing in 2024.
Capital Raise Risk
One risk facing the shareholders in the sector is that of a discounted capital raising. KPG, IPL, SPG and VHP appear the most at risk due to their high committed gearing levels, the sectors they operate in and their sensitivity to cap rate rises or valuation falls which could put their covenants at risk.
Capital raises at such a big discount to NTA would be a bad result for investors, so it would not be a surprise for companies to try to avoid this via the sale of properties (as KPG announced recently) or capital management strategies (discounted DRP’s).
Where to from here?
The property sector and the economy have shown remarkable resilience, fostering optimism that we may avoid a recession. However, despite the attractive discounts and yields currently on offer, we continue to remain cautious on the sector due to the near-term risks that overhang.
Inflation and interest rates, both locally and globally, both have further risk to the upside. Inflation, though declining, remains significantly above the target range. This, coupled with declining valuations or net tangible assets (NTAs), could impact the sector. Recent asset sales, such as KPG's Aurora sale at a significant discount to its valuation, underscore this reality. Property trends, whether upward or downward, tend to be strong and persistent. It's advisable to wait for concrete evidence of stability in sales volumes, prices, and the return of business, consumer, and investor confidence before making any moves.
Higher interest rates, while impacting valuations, have yet to translate into higher borrowing costs for listed property companies which are yet to roll over the low-yielding debt issues done in the past. This impending reality will come as a hit to profits and potentially dividends.
Given that most portfolios already hold substantial property exposure, it appears too early to contemplate adding to holdings.
In terms of preference, KPG and ARG are beginning to look attractive, offering a significant discount to NTA and an appealing dividend yield, provided they can maintain it. On the other hand, GMT, PFI, and VHP, though quality operators with strong outlooks, are trading at valuations and yields that suggest an overly optimistic future. Investors with large or outsized positions in these companies might consider trimming their holdings.
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