Falling into bad habits — A-REITs stretch dividends

Some real estate trusts use opaque accounting rules.

Falling into bad habits

Can a leopard change its spots? Can property trusts ever stick to just being landlords and paying a safe sustainable flow of dividends to income hungry investors?

It seems a long time since property trusts — now tagged with the moniker A-REITs — imploded in a sensational fashion back in 2007. And of course it is always dangerous to simplify: But the essential failing of that terrible collapse of the sector a decade ago was that many of the big trusts drifted from their original purpose. They started as landlords and developers and morphed into highly geared over-ambitious vehicles that tried to take on the world.

In other words, the big property companies failed the basic test for the investor — they created operations that were not sustainable. Anyone who got stuck in Centro or any of the other high-profile stricken trusts at that time will not forget the amount of money lost in what should have been dependable vehicles.

Now before we name names, it’s important to distinguish the mini-sectors within property trusts today — for example, a relatively new subsection of this market are companies which are not “all purpose” property trusts but rather asset managers of specialised properties, such as Arena which manages childcare centres, or Generation Healthcare which does a similar exercise at aged-care centres.

There are also property groups led by long-time management teams which have proved themselves very capable of riding out whatever the property market may throw at them in any point of the cycle — this would include both the Goodman Group and the Westfield Group.

Other trusts simply stick to their knitting, they may get handsome valuations but they don’t roam very far from what their stated purpose may be: Bunnings Warehouse Trust is a good example here. In fact, during the early stages of the current cycle we have seen the entire property sector improve its overall metrics. But now we are witnessing the very first signs of items investors should not welcome.

The context is that many properties — especially residential — are becoming expensive on many measures. Meanwhile, borrowing costs are low on any measure. In this environment property prices have been by driven by yield hunters who can end up eating their own capital. In tandem it’s easy to understand why a property company would take advantage of the fact that lending rates are lower than the rental yields they get from properties.

This is perhaps to be expected but here’s the scary part …

You would expect in a market where rates are at their lowest for a generation, economic growth is reasonable and there is a healthy (if yield driven) demand for property that every property trust could pay their dividends out of everyday business — or to put it technically, that dividends could be financed from free cash flow.

A report from Macquarie Bank — which is generally optimistic for the listed property sector — released just days ago singles out a string of property trusts that are not able to pay their dividends from free cash flow. The report notes that many property trusts or A-REITs disclose a number called FFO (Funds From Operations). But guess what? FOF ignores a whole lot of crucial costs such as:

• Incentives paid to tenants;

• Commissions paid to leasing agents;

• Capital spent on maintenance.

It is fair to suggest these costs — especially maintenance — are the essentials of landlord-style property companies, after all if maintenance costs gets excluded from a cash flow calculation that is a very big exception indeed.

When Macquarie did their own numbers using a textbook definition of free cash flow, some very big name groups came out at the wrong side of the exercise including: Cromwell Property, Charter Hall Retail, Investa Office Fund, ALE property group, Mirvac Group and Scentre Group.

You can see the degree to which the trusts depended on debt or equity rather than cashflow in the table above — if the group ratio is less than 100 per cent they are not covering their dividends from free cash flow, the lower the number the further from ideal the situation becomes.

No doubt each trust can explain the particular reason why they don’t meet the metric: Those explanations will centre on taking opportunities and meeting industry standards. But history suggests articulate and persuasive property managers can always explain their accounting decisions until it’s too late.

Macquarie does not spell this out, but the obvious question is if these trusts can’t pay for their own dividends from internal funds what on earth will happen to them if the property markets gets tougher? What if rents drop, if prices drop, it interest rates go up … and at least one of those outcomes will occur sooner or later.