Increased A-REIT gearing can be a good thing for investors: Mark Wist

Listed property trusts that increase their borrowings to acquire or develop property assets will increase returns to investors provided they generate returns that outperform interest charges.  

In 2006, the A-REIT sector, as represented by the S&P/ASX 300 A-REIT Index was geared at 37%.

Gearing is now 29%, having been lowered by a combination of asset sales and new equity capital raising. This has also been assisted by the upwards revaluation of underlying real estate assets over the past two years. Of the larger A-REITs, none has a gearing level above 40%. A global survey of investors by UBS concluded that gearing of 30% - 50% was appropriate.  

At the height of the GFC in March 2009, some A-REITs had gearing ratios substantially above 40%. Of the ten A-REITs with gearing ratios above 40% at that time, only one is still trading on the ASX. Names such as Macquarie DDR Trust with gearing of 60%, Macquarie Countrywide (59%), Babcock & Brown Japan Trust (58%), and Tishman Speyer Office Trust (56%) have all been acquired, merged or operate under new management. Pressure from lenders was significant. During the GFC the increase in corporate interest rates was part of a credit squeeze. These factors combined to reduce the net earnings of A-REITs.  

Gearing in other countries with listed REIT markets have higher gearing compared to Australia as interest rates are structurally lower. This is noted in Table 1.

Table 1: Average Gearing from Global Markets

Source: UBS, BDO  

Negative gearing occurs when the cost of interest on debt exceeds the income return earned by an investment. Gearing increases variability of potential return outcomes because of the fixed obligation to pay interest against variable income and capital returns as illustrated in Chart 2. Gearing amplifies prospective positive and negative returns. The marginal impact of gearing between 30% and 50% is not substantial. Gearing has a substantial impact beyond 60% when prospective negative outcomes are large.  

Chart 2 - Effect of Increasing Gearing on Property

At elevated gearing levels of 60% and higher, the risks of negative property valuation movements are exacerbated as there is a smaller protective equity buffer and higher exposure to increased interest payments on a larger debt.  

Several A-REITs have raised new debt or refinanced existing debt over the past year to take advantage of lower interest rates. A-REITs have also demonstrated an appetite to diversify the source of debt finance away from domestic banks to include offshore banks, and domestic and offshore bond markets.  Within the last three months, Commonwealth Property Office Fund raised $60 million and GPT raised $250 million through bond issues; Dexus raised $300 million in a private placement in the USA; and CFS Retail Property Trust raised $50 million in medium term notes and refinanced a $150 million bank facility. A total of $5.2 billion of debt has been raised or refinanced by the major A-REITs over the year to 31 May.  

A-REIT balance sheets are now in sound financial shape with low gearing ratios by bank credit standards, low interest rates, and stability of values in the property markets. Interest rates on debt are below yields on property assets. Property acquisitions will enhance return on equity.

Mark Wist is senior asset consultant at Atchison Consultants.