(From left to right) Mark Wilson, chief investment officer, and Andrew Scott, chief executive officer, at Centro The Glen in Glen Waverley, Victoria, Australia

In the midst of creating a strong presence in the U.S. retail REIT market, Centro Property Group faces a liquidity squeeze

By Charles Keenan

Centro Property Group (ASX: CNP), one of Australia’s leading real estate companies, has taken a decidedly American slant but now is in the midst of a liquidity squeeze owing to recent developments in the CMBS market. The Melbourne-based Listed Australian Property Trust (LPT), Australia’s equivalent to a U.S. REIT, has recently gone on a shopping spree in the United States, acquiring retail centers to help satisfy the investment appetite of its retail investors down under. However, that spree is now challenged by substantially changing conditions in the debt markets.

In its last fiscal year, ending June 30, 2007, the company acquired three U.S. retail property owners and operators: New Plan Excel Realty Trust, Heritage Property Investment Trust and Galileo Funds Management. It also bought out the stake of its U.S. joint venture partner, private equity firm Watt Commercial Properties.

Centro typically buys and operates community shopping centers, generally featuring non-discretionary spending retailers, such as grocery chains and discount box stores. “We are not focusing on the big flagship malls,” says Andrew Scott, chief executive of Centro. “We are after solid cash flow.”

Shoppers peruse stores in Centro Box Hill, a shopping center located in Victoria, Australia.

Despite the focus on steady rental streams, Centro has had to contend with recent concerns about asset valuations in the United States, which pulled down the company's share price last year. From early May to late October, its stock dropped 25 percent. At first, the plunge might not have seemed as drastic in light of the company's strong total return of 46 percent for the fiscal year ended June 30, 2007.

However, the company now must contend with more significant challenges. In December 2007, the company announced that it had cut its earnings forecast because of increased debt-refinancing costs, causing investors to strip 4.78 billion Australian dollars ($4.12 billion U.S.) from the company's equity market capitalization.

Centro also stated that, even though the company has performed well, it will not distribute a dividend for the first half of 2008. "Recent turbulence in international credit markets, in particular in the U.S., has resulted in a tougher environment in raising debt and refinancing existing debt facilities that are maturing," said Centro Chairman Brian Healey in the company's press release.

A Retailer by Any Other Name

Centro's portfolio spans more than 810 centers across Australia, New Zealand and the United States. Its tenants include U.S. discount retailers such as Staples Inc., Dollar Tree and TJX Cos. The U.S. portfolio also holds large grocers such as Kroger Co., Ahold USA and Publix Supermarkets, Inc.

The Centro Colonnades, located in South Australia, has more than 63,600 square meters and main tenants include Myer, Big W, Kmart, Woolworths and Coles.

According to Scott, focusing on these types of retailers gives Centro a first line of defense in case of a recession. Consumers still need to buy groceries and household items in a downturn. That could leave Centro less vulnerable than other U.S. retail REITs, which may hold a more diversified mix of tenants.

Analysts say that Centro's U.S. sites aren't in the nation's top markets. "The company's real estate focuses on necessity-based retailers in the U.S.," says Andrew Rosivach, an analyst with Credit Suisse in Sydney. "However, its portfolio is not always in prime locations."

If Centro's past success is any indicator, this specific concern may not hinder the company long-term. Part of its strategy is to add value to the sites it acquires by renovating stores, adding space or tapping its retail relationships to find a strong anchor tenant. "We have acquired some assets that needed work, and we had the opportunity to polish the jewel behind it," Scott says. "We don't have as many flagship developments as others. It's a collection of smaller assets that we turn into vibrant shopping centers."

However, Nicholas Vedder, associate at Green Street Advisors, Inc. says that these American purchases may have led to Centro's current challenges. "These American purchases have contributed to Centro's current downfall," he says. "It was an aggressive policy. They had left themselves little margin for error, and with declining property values and disruptions in the credit market, they've wound up in a tight spot."

A Two-tiered Approach

Centro's business model is different than most American REITs. Instead of direct ownership of assets, the company uses a two-tiered fund system to bring in co-investors, collect fees, diversify risk and leverage itself to buy more assets than if it owned 100 percent of its real estate.

Cave Springs Corners, located in Roanoke, VA, has more than 142,800 square feet and holds 15 tenants.

In the first tier, Centro owns 50 percent of two funds: Direct Property Fund and Direct Property Fund International. These funds have a 50 percent stake in other funds on a second tier. Through the two-tier structure, Centro has an effective 25 percent ownership position in the real estate.

Centro's executives believe that diversification also matches investor and management interests. "We want to reduce risk to Centro's investors by buying 25 percent of four properties, rather than 100 percent of one," Scott says. "It aligns our interests with other investors. Therefore, the potential for conflict becomes much lower."

American Roots

Centro began its rapid expansion in the United States in 2003, acquiring 14 assets in California under its joint venture with Watt Commercial Properties. It followed that by purchasing three big box retail centers in Atlanta in 2004. Shortly thereafter, it made its first U.S. REIT purchase in 2005, snapping up Kramont Realty Trust for $1.6 billion.

The next year, the company bought seven properties from The Westfield Group(ASX: WDC) for $47 million and later purchased Heritage for $3.2 billion. Last year it purchased Galileo for an undisclosed sum, bought out Watt in its joint venture and, in its biggest splash yet, acquired New Plan for $5 billion.

Courtland Towne Center, located in Mohegan Lake, NY, has more than 641,700 square feet and holds 51 tenants.

The New Plan purchase gave Centro 467 more neighborhood shopping centers, spread across 38 states with 68 million square feet of gross leaseable area. Many properties are anchored by grocers. More importantly, New Plan's management came along with the assets, including Glenn Rufrano, New Plan's former chief executive officer, who now is chief executive officer of Centro U.S. That gave Centro a strong platform from which to manage its rapidly expanding U.S. asset base.

"The New Plan acquisition filled an important need for Centro," says Jim Sullivan, a principal at Green Street. "Centro had acquired a good portfolio of U.S. assets but didn't have the infrastructure to run it."

However, Barry Vinocur, editor of REIT Wrap, The REIT Newshound, and the CEO and founder of REIT Zone Publications, LLC, says that the U.S. purchases may be the first sold in order to deal with Centro's credit situation. "They have a difficult time ahead," he says. "In order to deal with the credit situation, Centro is going to have to sell assets. They will have to decide what to sell and for how much. That won't be an easy decision."

Battling Concerns

The New Plan portfolio had a significant presence in slow-growth states of the Midwest and Northeast, a geographic distribution of properties that led to the concerns expressed about the price Centro paid for it. That doesn't rattle Scott, who says rapid-growth states have their pluses but also come with the downside of attracting competitors. More mature markets are tougher to penetrate.

"It's better to have a balanced and well-diversified portfolio," Scott says. "That includes some slow-growth areas, which are also areas with a low likelihood of new competition. Obviously, we want to have the A-grade locations within those areas, as well as the A-grade retailers to rent our centers. We do have a good defensive situation in those locations and have solid competing income streams."

Another concern among analysts is uncertainty with respect to asset values in the United States. "Like most Australian-listed managers with U.S. assets, there is the concern of asset valuations coming under pressure," says Peter Cashmore, an analyst at Citigroup Asset Management in Sydney.

"Its driver for earnings growth is to acquire and sell assets into various fund management vehicles," Cashmore says. "With the New Plan acquisition following closely after Heritage, they significantly increased their inventory. That caused some stress testing of the model as to how rapidly they can sell assets."

Yet another issue is the fact that the company has traditionally used more leverage than U.S. REITs and other LPTs.

Australian REITs Centro’s expansion into the United States is largely due to several factors specific to the Australian real estate market. One important factor is Australian pension laws, which require citizens to save 9 percent of income and wages. Add to that an aging Australian population with an appetite for capital stability and annuity-like income streams, and Australian REITs have become a popular investment choice. Australian REITs first appeared on the Australian Securities Exchange (ASX) in the early 1970s, buying up real estate across the continent to a point where 70 percent of all assets in the sector are now securitized. With so much capital flowing in from a country of savers—and a desire on the part of investors to diversify their real estate holdings—Australian REITs started investing in American real estate. Experts predict globalization of the Australian REIT sector will continue in the United States, and in other markets that have become REIT-friendly, such as Europe, Japan and Southeast Asia.

Going Forward

To be sure, Centro currently is battling a much tougher financing environment owing to the credit crunch, but the company may emerge from the challenge poised for more growth in the United States. While the company has hedged against the falling dollar to protect its U.S. income streams, it also could buy more U.S. assets if the Australian dollar continues to strengthen. Additionally, the Australian firm is poised to challenge its American retail competitors because most of the management team from the New Plan acquisition is remaining onboard.

"While we understand the difficulty that this presents to our security holders, the underlying retail property assets and performance of the business remains strong. The board and management are working hard to find an enduring solution to its financing requirements and preserving value for security holders," Healey said.

Vinocur says that the next few months will be interesting for the company. "If Centro decides to sell a lot of U.S. assets, it will ultimately impact the market. There will be a lot of opportunity for the U.S. REIT industry. We will have to see how this all plays out."