Galileo Japan Trust (GJT)

I briefly mentioned GJT in a previous post when they were working through a major re-capitalisation. I bought some units in the re-capitalisation and some more recently as the price has retreated. The current price of $1.43 implies a tax-deferred distribution yield of 10.5% p.a. It's pretty rare to see a double digit yield these days - that's over four times the RBA cash rate! 

In addition, GJT trades at a big discount to the NTA of $2.16, so potentially there is the double whammy effect of earning a big income yield and capital appreciation via a closing of the NTA gap. Imagine the NTA gap being mostly closed over the next three years to $2. The compound rate of return including distributions is 21.3% p.a.; double the long term average of the Australia stock market. This assumes constant currency and no growth in income or property values. 

It also assumes there is nothing actually wrong with the fund. That could prove to be a very big assumption. There are plenty of reasons to doubt GJT, so in no particular order, let's look at some of the potential issues. 

Currency Risk

GJT is un-hedged so investors are exposed to the Japanese Yen (JPY). There are no plans to hedge the portfolio - management noting the key reasons of not wanting capital tied up in hedging and the desire to get back to LPT '101' (Listed Property Trust - what REIT's were formally called) and offering a plain vanilla product to investors without complex hedging products.  

If JPY drops versus AUD, you lose. Vice versa. Here is a five year chart of AUDJPY:  

The AUD has appreciated approximately 50% against JPY. That was a little bit eye-brow raising. As an aside, I ran similar graphs for AUDUSD, AUDGBP and AUDEUR: 

The AUD has been a standout performer, however it started to slide against the GBP and EUR and to a lesser extent USD (although as I continue to edit this blog, the AUD has dropped about 2c v USD). Interestingly, it has held up relatively well against JPY. Key point: substantial currency movements have been known to occur. The 'steady' currency assumption is false. 

Japanese Macro Environment

Ageing population, extremely high public debt and deflation all come to mind when thinking about Japan's economy. Respected hedge fund manager Kyle Bass is famously extremely bearish on Abe's money printing policy. This is not a macro focussed blog and there are far smarter people than me commenting on the macro situation and I will not venture an opinion on this. 

Inflation can be superb for property investors: for example did you know a lot of McDonald's success is built on its property empire, created through debt and rising asset prices? Deflation however creates a huge problem for leveraged property investors: the NTA shrinks even faster than the deflation rate. GJT is 59% geared.  

Both GJT and Astro Japan Property Group (AJA) management are reporting a moderating in declining property values. There have even been the odd signs of increases in property values with the leader being A-Grade central Tokyo office property and a decrease in vacancy rates. Still, Japan has been in a bear/deflationary market for 20 years and it would be naive to think is no longer a risk just because of some tentatively positive signs. 

Square Peg, Round Hole

Last week I and some colleagues met with the managers of RNY Property Trust in New York. RNY and GJT both mostly hold non-prime real estate in foreign countries to Australia. Both vehicles aren't really a natural fit for out-of-the-way Australia, so closing the NTA gap may prove difficult unless there are more recapitalisations or asset sales, which don't appear to be on the radar following our discussions with GJT. These types of vehicles were set-up pre GFC and clearly there is a risk that locals offloaded dud assets to foreign (Australian) investors. 

And there are structural differences. GJT's debt is 59% versus the preference in Australia for gearing of 30-40%. Japanese REITs have debt levels averaging 60%. In Australia, commercial rents typically include CPI or 3-4% annual rent increases. It's done different in Japan: tenants are incredibly hard to evict and typically stay there for very long periods of time. It's not kosher for a business to change office location. Rent reviews, both up and down are done periodically causing the market to be a lot more fluid than Australia. For an Australian concerned about deflation, the structure of the Japanese market is a legitimate concern.  

Interestingly, Japanese listed REITS tend to trade at a premium to NTA.  The average yield has decreased from 6% (December 2011) to the current 3.8% p.a. So this is kind of odd with GJT trading at a big discount here in Australia.  This could open the arbitrage possibility of shifting GJT to Japan somehow. This option hasn't been ruled out. 

Further Property and Income Declines

I've already touched on this, however it's an incredibly large source of risk (and upside potential if values move up). Following the GFC, property values first started declining thanks to the cap rates increasing. Further property write-downs were then caused by shrinking income (lower income applied to the same cap rates equates to lower property valuations). The property declines have been dramatic: 2010 $58m, 2011, $41.8m. 2012 $40m, 2013 $10m. My case for investing in MPS was to buy when the write-downs had completed. Buying at a big discount to NTA when the NTA is still shrinking is not a smart move in my experience.

Income might also shrink if vacancy rates rise: GJT has an occupancy of 99%, which is significantly better than commercial space in general. I understand management have been very active in ensuring properties remain tenanted. I think this is smart: vacancies aren't a good look and give remaining tenants fire-power to negotiate down rates.

GJT v AJA 

I presented a basic comparison in my first post. One of the key differences is the debt repayment: AJA is paying down debt at a faster rate which means there is less available cash for distribution; hence why the payout ratio is 43%. GJT are not paying debt as fast and has a much higher payout ratio of 89%. There are pros and cons to each strategy. For my simple way of thinking, I like the higher payout ratio because it means I am receiving AUD much faster (lowering the risk of the investment) and as we know, dividends are such an important part of the Australian psyche, so a very healthy and sustainable yield is likely to act as a ballast for the unit price.

Summary

There are plenty of potential issues. But there is also plenty of upside. I own a small position and would love to add more if I get more comfortable risks start dissipating and/or the price moves down further.  

Kristian 

Disclosure: own GJT

Please get in touch! I am always on the lookout for interesting stock ideas, with a particular emphasis on deep-value, growth companies run by outstanding management and arbitrage opportunities.