Listed real estate trusts is one of the largest industry sector on the Australia Stock Exchange. There are a number of ways to invest in the the Australia institutional grade real estate assets where market depth is second only to United States, United Kingdom and Japan.
Examples of funds investing across institutional grade real estate asset classes include Westfield in Retail, Dexus in Prime Office, Goodman in Industrial. These REITs own some of the best commercial real estate assets in Australia.
Only because a market is developed does not make the assets a good investment. Real estate assets has had a great run in the last 2 years driven by the secular decline in interest rates and long term bond rates. The chase for yield has driven Australian commercial real estate cap rates, a primary metric in property valuation to reach the highs seen just before the financial crises.
Even as the value of commercial property assets are trading at record highs, AREITs are trading at am additional 10% to 20% premium above the net tangible book value. This means investors are paying a large premium on top of stretched valuations due to lack of income opportunities elsewhere. If you are an asset owner this is time perfect time to do an initial public offering to get the best price for your assets.
Viva Energy REIT
Viva Energy REIT (ASX VVR) is a specialized real estate REIT which owns service stations on a freehold and leasehold basis across Australia. The assets in the fund while being commercial assets are not in the traditional bracket of office buildings or a shopping centers.
It is targeting to raise 414.1 million shares at $2.20 making a targeted market capitalization at the offer price at $1.5 billion dollars. Viva Energy will retain a co investment stake in the listed REIT.
As a seller current low bond yields and inflated prices for assets with consistent yield means that this deal is a no brainer for Viva Energy. However from the buyer perspective, you would only buy this if you think the current low yield environment with the prevalence of negative yielding bonds will last forever. Just remember forever is a long time and the world changes fast. It was only 10 years ago that the financial crises is just getting started.
Investment Thesis
Similar to Hotel Property Investment (HPI) and ALE Property Group (LEP) the primary pitch for VVR is that it owns a portfolio of long term assets secured by lease income that grows at 3% per annum.
The properties are triple net leases which means that the tenant is responsible for all operating costs and capital expenditures of the building. Viva energy also have 7, 10 year options to extend the leases.
Growth Strategy
It will be interesting to see the growth strategy of the fund. Overtime we expect the underlying property value to fall as the leasing income which makes up a large portion of the present value of the cashflow is paid out. Rental growth and land value increases would offset this but we don’t think enough to maintain current valuations.
One avenue we see growth is a roll up play in absorbing other independent service stations. Given the VVR share price will trade at meaningful premium to book with sub 6% cost of equity. It can be a larger roll up play similar to G8 Education in the childcare sector by paying acquisitions with script.
Valuation
A key attraction of VVR is that the long lease terms ranging from 10 years to 18 years which provides proxy for income security. The Weighted Average Lease Expiry (WALE) which represent the security of the leasing income is 15.3 years which is specifically aimed at providing a cushion for future income for the security holders.
Since the fund is essentially a sale and lease back. Signing an eye popping lease term reinforces the security of income and to match markets insatiable demand for bond like assets. The fund’s income is entirely dependent on Viva Energy which means credit risk should also be factored in valuing the future income stream.
The forecast yield of 5.80% simply reflect where the market is at for similar priced assets.
The trade off for the buyers is that the asset value is priced to perfection and sold at additional 10% premium to book value.
Risk
One philosophical issue we have with these kinds of REIT is that only because an asset is secured against the a long life lease does not make it safer than assets with a shorter WALE. It is all dependent on the quality and location of the asset it self as well as the residual value after the present value of the cash flow.
For example if the service station is located in an area abundant with land the lease is not renewed. Then the downtime for the property to find a new tenant can negative the initial long lease if it ever finds a tenant.
On other hand, if a multiple tenant commercial building is located in the heart of the CBD with a WALE of 1 or 2 years. We would consider the risk of downtime after lease expiry to be manageable as asset in great locations are always in demand.
The key risk is how much of the current value incorporate the lease present value of the cash flow and how much is the residual value. The residual value will play a key role to determine the value of the security 15 years from now.
Since a number of properties are within residential areas, the pitch would also include alternative use upside. One question we have is what is the clean up costs associated with these properties before they can be converted for other uses. From the disclosure it looks like Viva Energy tenant will be responsible for the remediation. This again reinforces that buying the REIT is essentially taking on the credit risk of Viva Energy it self.