Probably the cheapest REIT in town …

Galileo Japan Trust

Back in 1990, Japanese wealth was being supercharged by one of the greatest asset bubbles in financial history.  Land prices in Tokyo reached such astronomical levels that it was famously said that the imperial palace in Tokyo was worth more than all the real estate in California! What goes up must come down and the real estate bubble popped in 1991. By 2004 residential property in Tokyo was worth less than 15% of their 1991 peak. Here is a graph of commercial real estate values for Japan’s six largest cities from 1971 to 2014 which illustrates the size of the bubble.

After the bubble popped, Japanese commercial property values fell rapidly to a low in 2004 and have gone nowhere in last 10 years.  However, there have been some recent reports that suggest that the property market is slowly recovering thanks to higher housing demand and the reflationary policies of Prime Minister Shinzo Abe. For an Australian investor, an easy way to get exposure to the Japanese property market is by investing in a Japan focused property group. Two such groups exist on the ASX: Galileo Japan Trust (GJT) and Astro Japan Property (AJP).  I like GJT better.

GJT owns the property portfolio through the Tokumei Kumiai (TK) investment structure.  The TK structure is similar to a silent partnership structure.  Under Japanese law this is a contractual relationship between an investor(s) and a TK Operator where the investor(s) provides capital to the TK Operator who acquires the assets and manages the business venture.  The investor(s) have neither control over the TK Operator nor the business venture but instead has a contractual claim against the business income and assets.

These schemes are set up for tax purposes and the net effect is that GJT will be entitled to 98.5% of the equity (TK Operator provided 1.5% of equity from its own account) and 97% of the profit/ loss of the TK business (TK Operator is entitled to the remaining profit/ loss).

• Portfolio

GJT controls a mix property portfolio made up of offices, residential, retail and mixed use properties located mostly in the Tokyo and Greater Tokyo area along with a few properties in Osaka.  A snapshot of its properties from HY2015 shareholder’s presentation:

As shown in the table below, properties values have been falling from 2010 to 2013 whilst gross property yield have been rising.  Occupancy levels have been steady over the last 4 years and close to 100% occupied.

In 2014, GJT sold two non-core properties:

1. Doshoumachi in Osaka for ¥800 million which is 14% above its carrying value; and
2. Lion Square in greater Tokyo for ¥2.385 billion which is a whopping 32.5% above its carrying value.

The results of these transactions may suggest that GJT’s valuation is on the conservative side or a result of them selling their best properties.

• Financials

I’ve re-calculated the earnings to the unit holders from the reported income statements and removed some of the one-off and non-cash items to give sense of the recurring cash profits attributable to the unit holders.  The pro-forma FY2014 earnings were previously provided by management during the re-capitalisation exercise in the 1^st half of FY2014. The recapitalisation exercise significantly reduced debt levels and this enabled GJT to revert back to its focus of managing its portfolio and paying distributions.

A few observations I would like to point out:

1. Management fees as a percentage of average portfolio value are broadly in-line with the fee schedule (0.65% management fee and 0.1% responsible entity fee –reinstated after the re-capitalisation).
2. One of the reasons why rental income in Australian dollars has fallen from FY2012 – FY2014 is due to the Australian dollar appreciating against the Yen.
3. One of the key reasons why EBIT has been declining from 2010 was due to the previous strategy of selling off properties to repay debt. As costs did not fall in tandem with the loss rental revenue, earnings declined.
4. Interest rate on the outstanding debt has also been falling. Based on the HY2015 presentation, the current effective rate is 3.3% p.a. (the above 3.5% was calculated based on finance cost and average debt balance).
5. Moving forward, without any significant changes to the portfolio, I expect the cash earnings to be in line with management’s pro-forma guidance. Based on the results in  HY2015, GLT is on track to meet this guidance.

Financial Position

As at 31 December 2014, GJT had $350.4 million in outstanding debt made up of senior debt (83%) and mezzanine debt (junior and senior) making up the remainder of the debt.  The loans are all due to mature in October 2018 and interest rates are mostly fixed from a fixed for floating interest rate swap facility.  As at HY2015, gearing (debt/ portfolio value) is 62.5% and interest coverage ratio (net profit before interest/ interest) is about 2.5x.  In my opinion, the gearing level is not excessive for a REIT with stable cash flows.

As at 31 December 2014, the book value per unit is $2.15 (which I consider to be its current intrinsic value).

• Dividend yield and price to book value relative to other REITS

After the recapitalisation exercise, GJT was able to pay distributions and have paid the following distributions:

• FY2014: 10.5 cents per share
• FY2015: 14.9 cents per share (estimated)

To get a sense of the recurring level of dividend based on the current portfolio, I estimate that the recurring earnings (assuming exchange rate remains at these levels) to be $17.2 million based on the pro-forma earnings adjusted for the loss of income from the sale of the two properties in FY2014 (they contributed to approximately 6% of the portfolio).  I understand that capital expenditure for maintenance and additions are circa $2 million a year, which leaves free cash for distributions around $15 million or 14 cents per share.  So I believe the current distribution level is sustainable (assuming no major drop in the ¥).

Comparison to other REITS (constituents of the REIT index) on the ASX:

Based on the above metrics (dividend yield and price to book value) it appears that GJT is the cheapest of this group.  There are 40 plus property groups trading on the ASX and some have a higher dividend yield GJT but I couldn’t find one that had both a superior yield and a lower price to book value than GJT.  In August 2014 GJT announced a share buyback program (maximum buyback lesser of $5.0 million or 10% of its capital).  So far it has bought back about $1.8 million worth of units at prices below the book value per share – great for existing shareholders.

• Margin of safety
  

I purchased the shares last year at $1.55 which provided a margin of safety of around 28%.  The margin of safety today (calculated based on the book value per share and current share price) has reduced to about 17%. Whether or not a margin of safety of 17% is adequate depends on your risk adverseness but for me personally, I would probably wait for another 5% pull back from current levels before taking the plunge.  I think with the current Greek problems, there is a real possibility of a drop to that level.

• Risk Factors

 An investment in GJT is not without risks and the key risks I see with GJT is:

1. A decline in the ¥ (GJT doesn’t hedge against movements in A$:¥)
   The chart below shows the A$:¥ over a 20 year period.  The average rate over the period is $1:¥81 and the A$ is current trading at the ¥94 level.  So the A$ is trading above its average historical level. I don’t know where the currency is heading to but I believe currency movements are cyclical and mean reverting. The quantitative easing (“QE”) policies in Japan which started in December 2012 have driven the Yen down by 2.3% and 19.3% against the Australian dollar and US dollar respectively.  If recent US experience is anything to go by, then the Yen should spike when the Bank of Japan starts to signal a taper in the QE program. 
2. Continued deflation in the Japanese economy
   I have no idea whether a deflation environment will further drive down property prices but land price data shows that commercial property prices in major urban areas have grown by 0.1% and 3.6% in 2013 and 2014 respectively. Obviously, a risk exists that deflation may take hold and drive prices down again.  However, intuitively speaking, if Japan’s inflation rate is persistently lower than Australia’s inflation then all things being equal, Purchase Price Parity theory states that over the long run, the Yen should appreciate against the Australian dollar.
3. Increasing maintenance expenditure (Capex)
   All of the properties in the portfolio were completed between the periods 1986 to 2005 with the majority built from the late 80s to the mid 90s.  So the buildings are not too old and average capital expenditure from FY2009 to FY2013 has been around $3 million a year. This is somewhat less tangible but I believe the Japanese culture of “taking pride and respecting their work place” should mean on average buildings in Japan are better maintained.
4. Natural disasters
   Japan sits at the meeting point of three tectonic plates and is therefore very prone to earthquakes.  There have been 69 earthquakes greater than a 7.0 magnitude that have occurred over the last 4oo years in Japan.  As a consequence, Japan has one of the strictest building codes in the world and after the 1978 Miyagi earthquake, comprehensive seismic requirements in building standards were introduced in 1981.  All of the properties in the portfolio have been constructed after 1981 and none of properties in the portfolio is currently insured for earthquake damage.  GJT’s policy is to procure earthquake disaster insurance for properties only where the PML is in excess of 15% (none at the moment).  I understand that this is due to the cost of earthquake insurance.
   Earthquakes are nearly impossible to predict and the probability of losses on the portfolio is beyond my capability to assess. So my strategy is too not put all my eggs into one basket and to exit the investment when the share price reaches its intrinsic value (this is not a hold forever type investment).

• Summary – Key reasons to like GJT
  
  1. The current dividend yield is attractive (dividends are tax deferred as well) and sustainable (if ¥ holds up). So my strategy is to collect a nice dividend while waiting for the share price to align with the intrinsic value.
  2. Recent properties sales may potentially indicate that the portfolio’s carrying value is below market value.
  3. It provides a hedge (not perfect) in the event the Australian dollar declines. Falling commodity prices and the RBA intent to drive the dollar down worries me.
  4. Tokyo will host the 2020 Olympic games.  This could be a catalyst for a boom in property prices as experience by many past host cities.

So why is the market pricing GJT at a discount to its peers? The most obvious answer to me is due to size, liquidity, GJT not being a constituent of the S&P ASX200 A-REIT index and market’s expectation of a continued decline in the Yen (which I’ve covered in the risk para).

• Size – GJT’s market capitalisation is less than $200 million compared with most of the REITS mentioned above which have market capitalisation in excess of $1 billion (National Storage market cap is about $500 million).
• Liquidity – GJT shares are not actively traded so liquidity is low. For example, 11,700 shares was traded today and I hardly see more than 100,000 shares a day being traded.
• S&P ASX200 A-REIT index – GJT is not a constituent of this index probably due to the size and liquidity issues and therefore unlikely to get the attention of the large institutional fund managers.