Brent Sheather: Price is not always right in finance

By Brent Sheather

Common sense tells you that if there were two gas stations in a town and one was selling petrol at $1 a litre and the other had it for sale at $1.50 a litre, the latter wouldn't do much business, except perhaps with those few poor souls who didn't pay enough attention at school.

In financial markets prices are normally pretty efficient - BHP shares trade in London and in the United States at a similar price to that on their home market in Australia.

BHP has the benefit of institutional shareholders who can afford to buy in one market and sell in another to exploit pricing anomalies.

Unfortunately, pricing efficiency doesn't seem to be a big feature of the personal finance market, where some products generate 5 per cent in commission when the same thing can be had for 1 per cent, annual fees of managed funds can vary from a high of 2 per cent a year to as low as 0.1 per cent a year, and portfolio management costs range from 0.3 per cent a year to more than 1.2 per cent a year.

While the investing public will carefully scrutinise interest rate offerings, the price of other financial services doesn't seem to be a big issue.

Continuing this theme of apparent pricing anomalies is the No 8 Airpark Drive Syndicated Property Scheme, better known as the Bendon building (B.b.), being marketed to mums and dads and, surprisingly, to high-net-worth individuals.

But the valuation metrics of the Bendon building seem at variance with pricing in the prime sector of the listed property market. It's not so much that the Bendon property is overpriced - its offer price is supported by a valuation from DTZ NZ - it's more that all the low-risk, safer, more liquid alternatives are selling for much less than they are worth.

First some background. The B.b. is an 11,700sq m prime industrial property, relatively new, with a long-term lease to Bendon. Bendon uses the building as its head office and international distribution centre. It is in George Bolt Drive and is being sold in 202 $50,000 parcels, primarily to retail investors.

The big selling point of the Bendon building is, of course, its cash yield of 10 per cent, which must look very attractive to people earning 4.5 per cent in the bank. But it is important to remember that while high dividends can be due to a low price, they can also be a function of financial engineering, in particular the cost of debt and the extent of that debt.

The Bendon building's cost of debt, at 6.2 per cent, is well below the yield of the property so the more debt the company has, the higher will be its yield to shareholders. The Bendon building will be financed 50 per cent by debt, which is high compared to the local listed property scene.

However, despite what you hear at those property seminars, high gearing at low interest rates is not a secret formula for success as high levels of debt can be very dangerous, particularly if the term over which the interest rate is fixed is short and, especially, if the economy looks like it's going to stop in its tracks (like now).

The B.b. loan is just for three years. If the company had sought 10-year funding the interest rate would likely have been quite a bit higher, if it were available. Shareholders should contemplate what happens in three years time. Will the banks refinance the loan if the property falls in value and gearing increases? What will the interest rate be? Higher rates mean dividends will take a hit.

At 50 per cent the gearing is about twice that typical of the biggest of the local listed property trusts. Most are limited by their trust deeds to 40 per cent.

There is probably no way you could float a listed property company on the Australian Stock Exchange today with 50 per cent gearing.

The stockmarket across the ditch is deathly afraid of property companies with high levels of borrowing in the current economic environment.

A number of its high-quality prime listed industrial and office property trusts, with better tenants than Bendon and long leases, but which also have gearing around the 50 per cent level, are trading at discounts to the market value of the property they own of 70-80 per cent and yielding more than 25 per cent.

The market worries that any further reduction in the value of their properties will send their gearing levels much higher, such that they may not be able to refinance their debt.

We can, however, strip out the benefits of B.b's. high levels of debt at low interest rates to get an idea of the fundamental value proposition before financing effects. Rent before costs as a percentage of the $19.7 million price of the building is 8.4 per cent.

If we calculate the same numbers for two of our largest listed property companies, Property For Industry and the AMP Office Trust, rent as a percentage of debt plus the sharemarket's valuation of the company is 9.3 per cent and 10.0 per cent respectively, much better value than B.b's 8.4 per cent.

Even with lower levels of more expensive debt, the average yield of the best listed property companies is about 2 per cent higher than that of B.b.

On the other key valuation metric, net asset value, B.b. also looks expensive. Even ignoring the $600,000 in initial fees and costs, the B.b. at the issue price will sell at what valuers think it is worth.

This sounds reasonable until you look at the local listed property market, where virtually every trust is selling at double-digit discounts to the value of the properties owned. The table shows that the highest-quality funds - AMP NZ Property Trust, Kiwi Income Property and Property for Industry - are trading at average discounts of 33 per cent.

These property valuations are about six months old but property prices are unlikely to have fallen by more than 10 per cent or so in the past six months and, with hundreds of tenants, including the Government, with varied leases and multiple buildings in different sectors of the property market, these listed funds are much less risky than a single property fund like B.b.

Interestingly, Augusta Funds Management, the manager of the B.b., also runs a listed fund, the Kermadec Property Fund. That fund is trading at a huge 56 per cent discount to valuation and pays a gross dividend of about 24 per cent.

One wonders what discount and yield the B.b. would trade at if it were listed on the stockmarket.

The NZ-listed property companies offer lower entry costs and prime property portfolios trading at double-digit discounts to valuation, with 12 per cent yields.

Listed funds also offer important things such as pricing efficiency and a liquid secondary market - you just might want to sell one day and, if you do, you would rather the price of the property be determined by a cynical but independent and unbiased third party like the stockmarket.

Finally, the B.b's. reliance on one tenant is not a good look. If firms such as Fisher & Paykel can get into trouble, Bendon could get caught with its pants down one day, too.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.

- NZ Herald

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