3 mis-priced yield plays

In September last year we penned a piece titled the ‘Impact of negative rates on global capital flows’ in which we laid out the case for increasing demand for higher yielding assets given the record low interest rates in sovereign bond markets.

“We think it’s likely private equity will look to deploy their record levels of capital into the public equity markets where there remains opportunities to buy quality businesses at reasonable valuations, which are actually cheap if low bond yields are here to stay. Assets that offer higher yields are being sought and this has been most clearly reflected in the positive re-rating of commercial real estate, REITS, utilities and other bond-like proxies.”
- Moelis Australia September 2019

This is a theme we expect to continue well into 2020. In fact, we have already started to see it play out with a private equity approach to National Storage REIT (NSR) at a significant premium to the REIT’s stated net asset backing. Paying a premium to a REIT’s net asset backing has been a common theme in mergers and acquisition activity over the last few years. This suggests that either private equity are paying too much or direct property valuations are too low. We side with the latter.

When considering a REIT’s asset backing it’s important to understand there can be a lag between new sales evidence and direct property valuations. Property valuations often rely on a broad spread of completed market sales evidence to establish appropriate pricing. Valuations therefore tend to be backward looking and require significant sales evidence before being updated. Direct property valuations are also likely to be slow to reflect the premium value placed on cash flows by international investors escaping low yields in their home markets.

To take advantage of this theme our small caps fund has recently acquired three new positions in the real estate sector. Each offers an attractive passing yield with the potential for growth and capital appreciation.

APN Convenience Retail REIT (AQR)

AQR owns a portfolio of 81 service stations across Australia. The portfolio has a weighted average lease term of 11+ years which supports an incredibly high degree of earnings visibility. The majority of leases provide for 3% p.a fixed annual increases with the tenant responsible for all outgoings.

The REIT offers an attractive FY21 passing yield of c.6.0% p.a with distributions paid quarterly. When combined with conservative gearing and a sensible acquisition strategy, distributions should grow at c.4% p.a, implying a double-digit return (yield plus growth).

In December 2019 a major development occurred with respect to the quality of the rental income from the portfolio. It was announced the major tenant, Puma Energy Australia (57% of gross income), was to be acquired by Chevron Corporation. This will significantly enhance the credit quality of the income stream given Chevron’s AA credit rating is far superior to Puma Energy Australia’s rating, which itself is only one notch away from non-investment grade.

The Puma portfolio assets were last valued using an average capitalisation rate of c.7%. We believe market evidence supports a 20%-40% increase in the asset values from a tightening in the capitalisation rate. For example, in December 2019, Charter Hall acquired half of BP Australia’s petrol station portfolio on a 5.5% capitalisation rate. While BP’s leases are slightly longer (20 years versus c.13 years), the annual increases are set with reference to CPI compared to Puma’s 3% fixed reviews. With Australia’s CPI running at just 1.7% p.a, the 3% p.a fixed reviews are clearly more attractive.

In terms of listed REIT comparisons, the most comparable listed peer to AQR is Viva Energy REIT (VVR) whose major tenant is Viva Energy Australia. VVR trades on a c.5.4% p.a distribution yield, which is c.60bps below AQR. While this was appropriate prior to the Chevron announcement, Viva Energy’s now inferior credit rating to Chevron further supports a tightening in yield for AQR.

In summary, AQR’s offers an attractive quarterly distribution yield which is underpinned by a thirteen year AA rated rental stream with 3% p.a fixed increases. Contrast that to Portuguese and Spanish sovereign ten year bonds offering an annual yield of just 0.25% p.a, no growth, and an inferior credit rating, and you can see why we favour AQR.

Elanor Commercial Property Fund (ECF)

ECF is a REIT which at IPO in December 2019 owned six high quality commercial office assets with strong underlying cash flows and significant value-add potential. At IPO ECF offered an initial yield of c.7.2% p.a. The underlying leases are expected to deliver rental growth of c.3.7% p.a, with the average rental term almost five years.

Shortly after listing, ECF announced a value enhancing acquisition of an office property in Canberra, which is expected to increase ECF’s underlying earnings yield by c.1% p.a.

We expect to achieve a passing yield of 8%+ p.a post the recent acquisition, which combined with 3%+ rental growth, should deliver an attractive double digit return. This is before potential capital gains should ECF re-rate closer to its peers which trade on yields of c.5.3 – 6.3% p.a.

Primewest Group (PWG)

PWG is one of Australia’s leading real estate funds management businesses and is well placed to benefit from the increasing demand for higher yielding real estate. The business currently has c.$4bn in funds under management, spanning seven asset classes.

The manager has a solid track record of delivering attractive returns to end investors. PWG has over 700 underlying investors (wholesale and HNW) in funds that are well diversified by geography and asset class. With limited fund expiries prior to FY25, these funds provide a secure and sustainable source of revenue.

PWG has no debt and c.$83m of cash, which affords PWG the scope to seed further wholesale/listed AUM growth and/or capacity for acquisitions of subscale peers. Both avenues have the potential to deliver material upside.

PWG’s founders each own approximately 20% of the fund ensuring they are well aligned with the business. The business is highly leveraged to AUM growth which is estimated could add 8% to EPS for every additional $100m of AUM growth.

Current pricing implies an EV/EBIT multiple for the funds management business of 12.4x or 8.1% of AUM, while delivering a 4%+ FY20 DPS yield (annualised).

Sounds like three mis-priced yield plays?