Down-to earth review issued of high-flying property stocks

Not everyone is convinced A-REITs can support today’s outlook and valuations.

Storm clouds are gathering over Australia’s property trust sector as rates head higher, settlement risk looms in the apartment market and bank lending tightens up.

But for many investors the key dangers might well be the lack of warning signals offered to them by the broader investment market, where favoured property stocks — also known as A-REITs — still ­receive glowing reviews from leading brokers dazzled by recent strong earnings results. Even though RBA governor Philip Lowe has effectively ruled out more interest rate cuts, top economists — such as David Plank, head of economics at ANZ — still predict there will be more easing.

The powerful run the property trusts have enjoyed over the past four years — they have outstripped every other sector in terms of total returns — can be ­attributed to a range of factors, but none is stronger than the “bond proxy” argument — put plainly, investors who have been very disappointed by low interest rates have turned to A-REITs for ­income returns that are still running at 7 per cent-plus.

As long as rates kept going down, A-REITS — and for that matter, REITs around the world — kept tracking higher.

But there are very strong indications the tide has turned: official rates in Australia are on hold while the key ­indicator rate — the 10-year bond rate — has moved from 1.8 per cent last August to about 2.9 per cent now. In the US, rates have moved even faster — the chairwoman of the Federal ­Reserve, Janet Yellen, has signalled that the US could lift official rates as much as three times in the year ahead.

Yet many leading brokers are still “hot” on Australian property trusts: Macquarie, UBS Credit ­Suisse and Morgan Stanley all have buy recommendations on property trusts.

But what if the economists who direct the brokers in their forecasts are just plain wrong?

Ben Brownette is a former stock analyst for Commonwealth Bank. Last year he joined Northern Trust as a senior analyst. Chicago-based Northern Trust is not very well known in Australia but it is one of the biggest fund managers in the world, running more than $US800 billion ($1 trillion).

Brownette is working for overseas fund managers who will not be distracted by local enthusiasm for major property trusts that have served domestic investors so well since the global financial crisis. As he suggests: “Markets do not ­believe in a rate cut, and think it is more probable we will be getting a rate hike.”

Maybe that is why Brownette has turned distinctly negative on Australian property trusts and ­offered a string of warning notes — the latest hitting the screens this week — that spell out a range of troubling issues coming down the line. In fact, Brownette has gone as far as putting a sell note on both Mirvac and Lendlease — which is no small thing in this closely watched sector.

Sell notes in the Australian market are rare in any sector; brokers prefer euphemisms such as underweight.

But at Northern Trust a sell note means a forecast drop for the stock of 20 per cent or more against its benchmark index.

Brokers can’t see trouble

In short, Brownette sees what he calls a “disconnect” between what his peers across the market see in property trusts and the ­reality on the street.

Asked what his key concerns are, Brownette spells them out as:

1. Investors and potential home buyers are facing higher borrowing costs.

2. Building valuations presented by property trusts have disconnected with reality by often ignoring the crucial lift in long-term bond rates.

3. Calls from economists who continue to predict further rate cuts, which in turn influence broker “models” supporting A-REITs.

4. New limitations on transferring money out of China that were only introduced at the start of the year have yet to fully take effect.

5. Commercial banks are lifting rates without waiting for official rates to move — investor loan rates have already moved up across the board.

To the casual observer, Brownette’s points would seem to make perfect sense.

Sure, there are some technical positives he may have underrated, such as the surprise swing of investors back into the property market at the tail end of last year. Though it is very possible that this was a knee-jerk reaction by some to the changes to superannuation ­announced at the time.

Either way, the remarkable ­aspect is just how out of line he is with the herd. As A-REITs performed strongly in recent years, they have collected a line of admirers who may be finding it very hard to change tack. In this line of thinking the analysts have a lot in common with economists still talking about rate cuts.

Earlier this week Macquarie signalled a change of stance as it made the industry-wide obser­vation that EPS growth estimates in the A-REIT sector have declined sharply from 6.8 per cent to 4. 6 per cent.

Separately, Credit Suisse made the significant move of downgrading the mighty ­Westfield.

In other words, Brownette is not alone; it might be that he is just well ahead of the pack.