Office A-REITS in spotlight as M&A activity heats up
By Doug Hoskins, Acting Fund Manager Centuria Metropolitan REIT
Are you an office property investor? Should you be?
Merger and acquisition activity was the dominant theme for office A-REITs in the third quarter of 2018 – highlighting the attraction of quality Australian office property to both domestic and international investors. Here Doug Hoskins, Acting Trust Manager for Centuria Metropolitan REIT (ASX: CMA), explains why there is so much interest in office property now and what the effect of the latest round of M&A activity is likely to be – as well as what he believes you should look for in a fund.
The tussle for ownership of Investa Office Fund’s (ASX: IOF) $4.4 billion-dollar portfolio has been very much the focus of A-REIT commentators over the past few months. Private equity giant Blackstone made its initial offer on 25 May 2018, but by 15 October 2018 it was Oxford Properties, the real estate arm of Canadian pension giant OMERS, which had won the day.
The deal itself is ultimately a good one for investors. IOF owns 20 investment-grade office buildings, located in core CBD markets around Australia (around 50% in the Sydney CBD), and tenanted predominantly by blue chip businesses. At the time of writing1, assets under management are valued at $4.4 billion.
Oxford’s offer of $5.60 per unit values IOF at a market capitalisation of $3.35 billion, which is a 23.1% premium to the ex-distribution price of $4.55 per IOF unit as at 25 May 2018, the day before Blackstone’s initial offer.
According to IOF’s directors, the all-cash offer represents an excellent opportunity for IOF unitholders to crystallise their investment at a certain and attractive price, and the fund manager spoke of the ‘considerable value’ created from the portfolio. By all accounts, Oxford has been looking to expand into Asia and Australia for some time, and according to the Australian Financial Review, the fact that Oxford outbid Blackstone is a “victory for pension fund capital over private equity”.
At the smaller end of town, there has been plenty of activity as well. American investment firm Starwood Capital Group offered $480.3 million for the Australian Unity Office Fund (ASX: AOF), an offer it subsequently revised down by 2.7% to $467.4 million following due diligence. According to the AOF Board’s calculation, the revised price represents around $2.87 per unit. As a result, the Board has reversed its earlier support for the bid, despite the fact that the new offer, while lower, reflects a 7.5% premium to the 30 June 2018 (last reported) NTA per unit for the trust’s portfolio of nine predominantly metro office properties.
Starwood may or may not ultimately agree terms with AOF, but regardless, these deals are clear evidence of strong international interest in Australian office property, and there are several reasons for this, which I will explain in more detail below. Regardless of what Oxford and Starwood (if its bid ultimately succeeds) decide to do with their newly acquired property portfolios, if they decide to delist IOF and AOF , it would take close to $4 billion out of the A-REIT market and significantly affect the remaining players – including our own CMA.
Why A-REITs, and why now?
Firstly, A-REITs have been performing strongly. The sector outperformed the wider equity market over the quarter, and the year, to the time of writing1, for several reasons.
A-REITS are considered a defensive play in volatile markets – and bond and equity markets continue to be volatile. Concerns about a trade war between China and the US has been weighing on investor’s minds – and as a result, in the quarter to 30 September 2018, A-REITs outperformed the general market, finishing the quarter up 2%, 0.5% ahead of equity markets over the same period.
At the same time, the Reserve Bank of Australia (RBA) kept rates on hold at 1.5% for the 23rd month in a row. Given the growing differential between short interest rates in the US as the US Federal Reserve lifts rates and the RBA holds, the Australian dollar weakened against the greenback, making office assets more attractive to overseas bidders.
Merger & acquisition activity is good news for the sector
The IOF and AOF deals are clear evidence of ongoing demand for Australian office assets. In our view, office market fundamentals in Australia remain positive, and this view is backed up by international investors. According to global listed real estate giant Principal in their September 2018 quarter global REIT roundup, office market fundamentals in Australia continue to look robust, and Australia overall is one of the few global office markets with room for further cap rate compression.
On the other hand, if the sector continues its trend towards consolidation, the universe of listed office investment opportunities will continue to reduce. At the same time, the trend of retail investment sentiment migrating to larger capitalisation office and industrial opportunities is likely to continue given the comparatively weaker performance of retail property. The net result will be that quality listed office offerings are likely to be in strong demand – and the beneficiaries of capital looking for a home.
Centuria Metropolitan REIT (ASX: CMA), for example, is close to becoming one of the largest metro office A-REITs in the market, with solid metrics and a quality portfolio. At the time of writing1, the portfolio is 99% occupied with a long weighted average lease expiry (WALE) of 4.2 years. The distribution yield of around 7.3% is underpinned by a diversified income stream.
Identifying quality A-REITs: What to look for
A-REITs can provide diversification benefits to a portfolio, helping to maximise risk-adjusted total returns – and may provide reliable income returns, particularly when interest rates are low. The big question for investors is how best to evaluate the different options.
There are several factors that investors should consider when assessing office A-REITs:
- How reliable are the earnings and how likely are they to remain stable over time? A-REITs that actively manage a portfolio of quality properties are historically more likely to provide investors with a stable income from returns than those that make a substantial percentage of their profits from development.
- Look at the portfolio WALE: A long WALE is a general indication that income is locked in.
- Conservative capital management is key to keeping risk under control. In particular, conservative debt levels mean interest rate coverage is likely to be better, and the distributions steady.
- Is the distribution payout ratio sustainable? It’s important to keep some cash on hand to maintain assets and to pay unexpected expenses.
- Manager experience through a number of property cycles, with a clearly defined and communicated strategy is also important.
- Your risk appetite. As with all investments, there are risks involved with investing in A-REITs and we recommend that you review the relevant disclosure document(s) and seek professional advice before making any investment decision.
The recent M&A activity in the A-REIT sector is a sign that quality Australian office property remains in demand from overseas and local investors. In our view, it is likely that consolidation of the industry will continue as investors seek the returns on offer in the Australian property market. We believe that strongly-performing, well-managed A-REITs will have the advantage when merger and acquisition activity sees other players taken out of the sector, and we expect that quality A-REITs will likely benefit from an influx of capital looking for a home.
1 20 November 2018
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