Back in 2007, the wheels began to fall off the global equity market rally. The key driver was a tightening within credit markets globally to the point where some companies were completely frozen out and couldn’t refinance their debt. The REIT sector was the epicentre of the crisis in Australia and the poster child for problems was Centro Property Group.

Centro operated as a funds management company with ownership stakes across the underlying investment funds. These funds then undertook developments, and deployed capital. After an initial equity raising, the funds would use debt to complete developments whilst booking revaluation gains. The head company, Centro would use debt to fund their equity stakes in new funds and increase their gearing there as well, effectively creating gearing on gearing.  As a result the financial statements were opaque and the company hid negative cashflow and rising debt levels behind asset revaluations. This behaviour was prevalent across the industry and other players such as Goodman Group, Charter Hall and GPT were all forced into deeply discounted equity raisings just to survive.

When you look back at history and examine businesses that have failed, they all have one thing in common. High debt levels combined with insufficient or negative cashflow. Typically these companies will rely on capital markets to fund their operations and when those capital markets close, the music stops. This happened in 2007 for the REIT sector and the poor capital management was exposed.

Understandably, with interest rates starting to rise globally, investors are now starting to get nervous and many worry about a repeat of 2007 and 2008. However, when we look across the sector we do see vastly improved capital management in recent years than we did during the previous bull market. The funds management model has evolved and companies such as Charter Hall and Goodman Group have become more efficient at using other people’s capital and taking less development risk on their own balance sheet. The potential problem for them comes if that capital pipeline dries up and rising rates could potentially do that. If demand for property funds fall then earnings could falter. As a result we don’t think it’s necessarily a good time to buy REITS but given their vastly improved capital structures we don’t believe solvency is an issue like last time.

Elsewhere in the sector, some companies do have elevated gearing levels and will feel some pain such as Cromwell (who has recently been downgraded by Moody’s), although again we are not overly concerned around solvency. In fact, of all the major REITs we would consider Westfield as the one most reliant on capital markets and hence most at risk. Since spinning out Scentre back in 2014, the company has been in development mode and as a result has had negative free cash flow, rallying instead on capital markets to finance its growth. With a $9bn development pipeline left to complete this need for funds will continue for a number of years yet, whilst at the same time valuations of Retail property assets are coming under pressure globally.

Given we don’t expect REITs to be the epicentre of the next crisis; it’s worth looking at what sectors might be. The obvious answer would be the financial sector and obviously the banks are under scrutiny from investors but the rise of the small cap finance sector warrants some watching with a large amount of junior companies operating in niche sectors. Another popular sector amongst investors that stands out due to complex financial reporting is the Aged Care sector.

As we mentioned above, the characteristics that lead to business failure are debt levels that are too high and insufficient cashflow. In the Aged Care sector we worry that the companies are potentially understating the amount of debt they have and overstating their cashflows. This phenomenon comes about through what is referred to as Refundable Accommodation Deposits (RADs). The RADs are a lump sum payment paid upfront for entry into an Aged Care facility. They can be used for multiple purposes and sit on the balance sheet as a liability but not as pure debt. As a result they can be used as a third source of funding (alongside equity and debt) and can effectively be used to increase a company’s return on equity. The current listed players (Estia Health, Japara Healthcare and Regis Healthcare) have historically used these funds plus debt to make acquisitions, adding more RADs and hence more funding to the balance sheet. In addition some of the listed players include the change in RADs in operating cashflow, which potentially overstates the cash they are earning.

If we take Estia for example, we find their current debt level is $121m against $1,798m of total assets. At first glance it appears there is nothing to be worried about (a gearing ratio of 6.7%), however we delve a little deeper we discover some cracks. Of the $1,798m of assets we find $1,036m are intangible, predominantly goodwill from acquisitions. In addition the RADs on the balance sheet are $730m; hence if we were to include these as debt (they do have to be repaid and the holder does receive government mandated interest) the company has negative Net Tangible Assets.

The problem for these companies comes about if the proportion of residents who pay via RADs starts to fall.  If this proportion does fall, these companies will experience potentially negative cashflow in what is effectively a forced reduction in debt. A large reversal in resident behaviour would cause tremendous financial strain. The three major players are all recent listings that came to market riding changes in legislation (the Living Longer Living Better reforms) and a thematic that investors were exciting by (an aging population). However, at the heart of these companies are low returning assets juiced up by financial engineering and subject to regulatory scrutiny. We don’t believe the sector has been fully tested as yet and we worry about what happens when it is.