It's hard not to respect Woolworths (WOW) for the job they have done over the past 20 years or so, building their brand and diversifying their business to the point where they are as ubiquitous as the Australian sun.
Although they have assets and businesses outside of supermarket retailing, their sales are predominately driven from prime physical locations that have developed into a significant property portfolio.
As part of a strategic review, the company has decided to split off the property portfolio from the rest of the business into a new entity called Shopping Centres Australasia Property Group, or SCAPG.
SCAPG listed yesterday as an ASX Real Estate Investment Trust (REIT) and owns 69 "neighbourhood, sub-regional and freestanding shopping centres".
The main reason for the divestment is to enhance Woolworths' return on shareholder equity, which has historically been very high, by removing elements such as property assets from the balance sheet. These, by their very nature, dilute more productive returns from the core business of selling soap and sausages.
Existing Woolworths shareholders got one SCAPG stapled security for every five Woolworths shares, with access to an additional underwritten offer of about $200 million for SCAPG shares.
One of the headlines we saw on this deal was from ABC News, stating: "Woolworth ditches shopping centres".
The question for investors, though, is if Woolworths is selling off these assets to enhance their returns, why should you buy them?
It's a good question, but before we can answer it we need to discuss how a REIT makes its money. As a property business, a REIT makes its money from the rent or lease it charges on assets it owns, and then from any profits from development, divestments or ephemeral balance sheet revaluations (I use the term "ephemeral" advisedly).
Administration fees and interest costs are obviously deducted from any cash flows, so it is important to consider the leverage and management capability of the business, and on this deal the SCAPG explanatory memorandum from Woolworths states:
"SCA Property Group will provide investors with access to new retail property predominantly exposed to non-discretionary retail spending, which is expected to generate attractive and reliable returns over the long term.
"SCA Property Group's earnings are underpinned by long-term leases backed by the strength of the Woolworths Group as anchor tenant."
While a property trust wouldn't normally be considered a fixed-income investment, REITs do have similar characteristics and attributes that investors desire, the obvious one being the headline yield. And, indeed, from their distributions, REITs pay a yield just like a bond or term deposit.
Looking further into the SPACG offer: "SCA Property Group will have a forecast distribution yield of between 6.9 per cent and 8.3 per cent for its first full financial year to 30 June 2014, dependent on the final price of the offer."
But herein lies the issue: SCAPG isn't a bond, even though it is effectively being "sold" as a yield play. Of course, bond prices are not exempt from speculative ructions on the market and their prices go up and down like a share or listed security. (Remember, bond prices move inversely to those of yields because the value of the coupon they pay reduces or increases in value as rates fall or rise.)
The present value of the rental streams in a REIT is similarly worth more or less, depending on the interest rate outlook.
But the value of the real estate assets is also important to the valuation of a REIT. Unlike a bond, whose value increases as the economy weakens and interest rates drop, the valuations of property assets would be subject to downward revision, if only by the market on the ASX where SCAPG will trade.
And what is therefore most concerning with the SCAPG issue is that analysts have contended that the properties within the SCAPG portfolio are non-core; that is, not the "best-dressed" list but rather the under-performers from a return-on-equity viewpoint.
As the macro theme of a cautious consumer continues to roll on, the question of the future valuation on these non-core properties is raised.
We saw this valuation challenge in the depths of the GFC when property trusts were sold heavily by a market concerned with the outlook for the economy, the outlook for occupancy and the outlook for property values. The funny thing about this is that if the rental occupancy holds up then the yield on the REITs actually rises as the valuations of the REITs' assets fall.
So whereas bonds offer a counter-cyclical hedge to the economic circumstances in a balanced portfolio, REITs have a huge element of pro-cyclicality.
Indeed, my personal view has always been that I don't want to hold REITs unless they are distressed and at a serious discount to net asset value. In simple terms, I would only hold them to take advantage of the cycle, which implies timing asset allocation. This is not a downside of course, as almost all risky investments by their nature require an element of market timing, but this definitely means that REITs are not suitable for the secure, conservative and yield-oriented portion of your asset mix: your fixed income portfolio.
Greg McKenna is the former treasurer at Newcastle Permanent Building Society, where he was responsible for funding, liquidity, balance sheet and interest rate management for the $7.5 billion institution.
This is an extract from a longer article available free at MacroBusiness.