Brian Gaynor: Cheeky offer for Capital Prop

The takeover offer for Capital Properties raises the important issues of property valuations, management contracts and the valuation of companies subject to bids.

AMP Property Portfolio is offering $1.42 a share compared with Capital Properties' net asset value of $1.29 a share as at March 31.

Is the $1.29 a share net asset value accurate and has it increased over the past six months?

Capital Properties' directors believe that the company's management contract is worth an additional $35 million to $40 million, or 14.5 cents to 16.6 cents a share.
Is this assessment realistic and, if so, does it signify that the AMP offer is too low?

This story began on November 19, 2004, when Kiwi Income Property Trust acquired 19.9 per cent of Capital Properties on market at $1.15 a share. The purchase price compared with Capital Properties' net asset value of 95c at the time.

Kiwi announced that in the event that it bought any shares in Capital Properties at a higher price in the next 12 months it would compensate all sellers by paying them the same amount. This escalation clause reduces the prospect of Kiwi outbidding AMP for Capital Properties.

A week after the on market purchase chairman Colin Beyer announced that Capital Properties was proposing to sell its management contract to an outside party.

On December 21 the Wellington-based company revealed that its net asset value had risen from 95c to $1.18 a share.

At the same time Angus McNaughton, chief executive of Kiwi's management, objected to the sale of Capital Properties management contract. He argued that the sale would reduce dividend payments, an ironic claim from McNaughton.

The next important development was on March 8 when First NZ Capital announced that it had received instructions to acquire 23 million shares for an undisclosed client at $1.35 a share. Later that day AMP revealed it had purchased 10.4 per cent of Capital Properties.

The following month Beyer told the NZX that the management contract was no longer for sale and the company's net asset value had risen to $1.29 a share as at March 31.

In May AMP bought additional shares to raise its stake to 15.6 per cent.

AMP Property Portfolio, which is the AMP entity bidding for Capital Properties, is a private unlisted fund with property assets of $591 million. These include a 50 per cent interest in three Auckland shopping precincts, Botany Town Centre, Lynnmall Shopping Centre and Manukau Supa Centre.

The Superannuation Fund recently announced that it was investing $78 million in AMP Property Portfolio.

There are a number of ways of valuing property companies but net asset value is the most commonly used.

The value is determined by total rental income and the rental yield. If the rental yield is high then the value of the property portfolio is low and when the yield is low the portfolio's value is high.

As the accompanying table shows the rental yield for listed entities varies from 9.5 per cent for ING Property Trust to 6.9 per cent for Calan Healthcare Properties Trust (Trans Tasman Properties disclosure is poor and it is not possible to determine its rental yield but it is estimated to be below Kiwi).

As a general rule investors tend to value companies with a high rental yield at a premium to net asset value because their net asset value is considered to be conservative.

Conversely property entities with low rental yields are considered to have fairly fully valued properties and their share prices usually trade at a discount to net asset value.

Capital Properties' portfolio was valued on an 8.9 per cent rental yield as at March 31. This is at the top end of the yield range. (It should be noted that the listed entities have a mix of commercial, retail, industrial, healthcare and development properties and the yields on these property types vary.)

The Wellington commercial property market, which represented 53 per cent of the target company's, has been booming and Capital Properties should announce a significant property revaluation in response to the AMP bid.

In April Jones Lang LaSalle reported that the Wellington office market had shifted from an occupiers to an owners market. Vacancy rates had fallen to record low levels and average gross CBD office rentals have increased by up to 20 per cent in parts of the city over the previous six months.

The latest Property Council investment performance index shows that the Wellington office sector was the best performing sector in the year ended June 2005. For that 12 month period the capital's commercial sector recorded a total return of 24.6 per cent compared with 15.3 per cent for Auckland commercial property.

AMP NZ Office Trust's rental yield declined from 8.2 per cent to 8.0 per cent between December 31, 2004 and June 30. If Capital Properties reduces its rental yield from 8.9 per cent to 8.5 per cent or below then it will announce a significant increase in net asset value, particularly as the company is relatively highly geared.

Previous independent appraisal reports, particularly the 1999 report for Capital Properties' acquisition of Shortland Properties, have taken into account the average market premium (discount) to net asset value and used this to value the target company. If Trans Tasman Properties is excluded - it is selling at an unusually big discount to net asset value because of poor corporate governance - then the NZX listed property entities are trading at a premium to net asset value. This will help boost Capital Properties' valuation.

The other important consideration is that Capital Properties owns its management contract whereas most of the other listed entities have externally owned management contracts. The company estimates that the management contract is worth $35 million to $40 million or between 6.2 per cent and 7.1 per cent of gross assets.

As a number of management contracts have changed hands between 6 per cent and 7 per cent of gross assets this seems like a reasonable assessment of value.

If the bid by AMP Property Portfolio is successful Capital Properties will be split up. The assets will go into the property fund whereas AMP will be given the management contract. As AMP charges AMP Property Portfolio a management fee of between 0.50 per cent and 0.55 per cent of gross assets then it will receive an annual fee of between $2.8 million and $3.1 million from Capital Properties based on March 31 valuations.

Capital Properties' portfolio will be revalued and AMP's fee will be higher than this.

As the management contract represents additional value to AMP in excess of net asset value it would be extremely silly if Capital Properties' shareholders accepted a takeover offer that didn't include full consideration (at least 14.5 cents a share) for the management contract.

AMP Property Portfolio - which will be desperate to acquire Capital Properties as it will want to generate a good return on the Superannuation Fund's $78 million investment - went on the front foot this week.

Stephen Costley, who is AMP Property Portfolio's general manager, told the Business Herald that the initial feedback from retail sharebrokers indicated Capital Properties shareholders were more than willing to agree to the deal.

It is difficult to know where Costley obtained this information as most market observers believe that Capital Properties is sitting on a proverbial gold mine in Wellington, particularly as there is a strong chance of another centre-left government after last weekend's general election.

Capital Properties' shareholders are advised to wait for the independent appraisal report as it is expected to produce a higher valuation than AMP's cheeky $1.42-a-share offer.

* Disclosure of interests; Brian Gaynor is an executive director of Milford Asset Management whose clients hold Capital Properties shares.