The collapse of North America’s biggest telephone equipment maker, Nortel Networks Corporation, on Wednesday January 14, 2009, after it filed for bankruptcy, is a timely reminder of the dangers of overconcentration and the importance of diversification. Once the darling of the Toronto Stock Exchange (TSE), at its peak during the technology bubble of 2000, it represented more than one third of the TSE 300 index. Another example offshore of single stock concentration within indices can be found in Nokia Corporation, which currently accounts for about one third of the total market capitalisation of the Helsinki Stock Exchange.
But this phenomenon is not restricted to offshore; it’s right in our own backyard. Westfield Group, as at December 31, 2008, made up 45.2 per cent of the S&P/ASX 300 Property Accumula tion index, having further entrenched its dominant weighting in the index, thanks to its strong perfor mance relative to peers over the past 12 months. By way of comparison, the largest stock in the S&P/ASX 300 Accumulation index is BHP Billiton with a 13.6 per cent weight.
While concentration is not a new issue facing the listed property trust sector, what is, is the magnitude of this concentration within a single stock. Previously it was contained to the “Fab Four” – Westfield, GPT, Stockland and Mirvac – and a de cade ago, prior to the consolidation period resulting from the stapling of securities, the benchmark was significantly more diversified.
The stapling trend fundamentally changed the risk profile of the sector, given it introduced corporate development / construction risk and other risks associated with non-core rental income streams (that is, funds management). The most common form of stapling occurs when a listed property trust is combined with a related devel oper or property management company.
The trust continues to hold the portfolio of property assets while the property company manages (now inter nally rather than externally) the funds or pursues development opportunities/funds management, et cetera.
The other trend that emerged over this period, which is associated with a shift in the underlying businesses of listed property trusts, is their level of gearing. A decade ago, the sector had an average debt to asset level of 10 per cent versus 40 per cent plus more recently.
An outcome of the changing nature of listed property trusts is that the sector is now more volatile than in the past (Centro being symptomatic of this broader observation), it has become more “equity-like”, it has become a less effective surrogate property investment and its appeal as a diversifier in portfolios has waned.
PITFALLS OF OVERCONCENTRATION
This increased level of concentration in the listed property trust market raises concerns over the effectiveness of standard fund design (that is, it’s harder for active fund managers to reflect their views and deliver consistent value add), its impact on reduced diversification, the resultant increase in volatility and the payment of active fees for a significant portion of the portfolio which is “index-like”.
So what’s in store for the sector going forward? Back to basics is the proposition being much discussed – lower debt, domestic focus, non-stapled securities and a focus on annuity rental income streams. But there is some uncertainty about the execution of this “back to the future” strategy, and in this context investors should be considering global listed property as an alternative.
SHIFT FROM DOMESTIC TO GLOBAL
Some of the benefits include:
– Country diversification. Currently there are 21 countries in the global benchmark (FTSE EPRA/NAREIT index), with a shift away from being US-dominated, given increased property securitisation across emerging markets;
– Sector diversification. The Australian benchmark doesn’t have any significant exposure to hotels, residential, healthcare and specialist sectors and is skewed towards retail assets;
– Stock diversification. Westfield Corpora tion has the largest weighting in both benchmarks yet makes up 45.2 per cent of the S&P/ASX 300 Property index versus 4.3 per cent of the FTSE EPRA/NAREIT index. Similarly, the top five stocks in the Australian versus global index have an aggregate weighting of 79.0 per cent versus 18.9 per cent respectively, while the number of stocks in the investible universes are 28 versus 282;
– Sector efficiency. The Australian listed property sector is well developed and heavily researched. Approximately 31 per cent of the real estate universe is listed in Australia versus 5 per cent globally (source: EPRA). Newly securitised markets tend to be less efficient and prone to mis pricing which creates investment opportunities for active fund managers;
– Domestic benchmark relevance. With Westfield holding about half its assets offshore and the total weight of offshore assets within the constituent stocks of the S&P/ASX 300 Property Accumulation index also about 43 per cent, the relevance of a domestic index comes into question.
IF NOT GLOBAL, WHAT ALTERNATIVE?
The total number of real estate investment trusts (REITs) on the ASX totals 63 stocks, with a combined market capitalisation of $51.5 billion. The S&P/ASX 300 Property Accumulation index comprises only about half of those REITs listed (that is, 28 stocks) with many excluded due to the fact they are deemed either too small or too illiquid. The potential investible universe expands even further if you include real estate management and development companies, which total 47.
With “active” fund managers still in many cases bound by tracking error constraints, while also often keeping an “eye” on their relative performance, a new index (with a different construction tech nique adopted, which caps or limits the Westfield exposure and/or broadens out the number of trusts selected) needs to be adopted as the standard industry benchmark.
As a sign of the times, effective December 2008, a number of indices in the FTSE EPRA/NAREIT Global Real Estate Index Series have introduced a level of fixed capping at 10 per cent for each constituent to avoid overconcentration.
We need to stop talking the talk and start walk ing the walk when it comes to diversification and risk management. And a change to the benchmark ing of the domestic REIT sector is as good a place to start as anywhere.