Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: So, Shani we are going to do another share deep dive today. And this one is listener requested. So it’s from Steve, and he requested we do an episode on Charter Hall Long Wale REIT with the ticker symbol CLW. So why don’t we start with some basics. What does WALE stand for? 

Jayamanne: Well WALE stands for weighted average lease expiry and that means the average lease expiry period. So, in the case of long WALE, we are looking at lease expirations far out in the future. 

LaMonica: And talking about leases of course makes sense because we are talking about a REIT or real estate investment trust which is a company that owns property. 

Jayamanne: Now at the risk of having 90% of people stop listening to this episode we have a bit of a disclaimer. REITs do not pay franking credits. 

LaMonica: And the reason they don’t pay franking credits is because they aren’t technically companies. They are actually trusts – real estate investment trust. Which means that earnings aren’t taxed at the REIT level. And because of that they can’t pass along credits for taxes paid. And technically they don’t pay dividends. They pay distributions which legally must be 90% of the profits. 

Jayamanne: So now that we’ve driven off the franking credits crowd let’s talk a bit about the REIT. They of course own property because they are a REIT, but there are all sorts of different types of property with different profiles that REITs can own. In this case they are a diversified REIT meaning they own property across the office, industrial, retail, social infrastructure and agricultural logistics space.  

LaMonica: And they have a $7b portfolio that consists of 550 properties. And one of the keys to investing in REITs is understanding the quality of their property portfolio. Because unlike people not every property is created equal. 

Jayamanne: In this case our analyst has some really good things to say about their property portfolio. He deems it high quality for a couple of reasons which largely have to do with their tenants. Liquor and pub operator Endeavour Group is the largest tenant and represents 18% of their income. That means that indirectly Mark supplies about 9% of their income. But our analyst says that four fifths of their income comes from tenants that he believe are unlikely to ever miss a rent payment including the aforementioned Endeavour group, government agencies, Telstra, BP, Inghams, Coles, Metcash, Arnott’s, Bunnings, Westpac and Linfox.

LaMonica: Quite a list of names there. So, we know they have a good property portfolio with solid tenants, but we need to look at the types of leases they have with these tenants. We talked a minute ago about why WALE is in the name. Well, the weighted average lease length as of December 31st 2022 was 11.8 years. Which when you have tenants unlikely to miss a rent payment leads to a very predictable earnings stream. Which we of course like as investors. But another component of a lease is not just the length but also the other terms. More than half of the leases are triple net. That means that the tenant pays all the cost associated with the property. That includes taxes, maintenance and insurance. A pretty good deal for the property owner. 

Jayamanne: The other thing that is important is how rent increases over the course of these long leases. Half their leases are CPI-linked which is a good thing to protect investors from inflation. Inflation is incidentally something we are all worried about. We expect a 7.2% average increase in rents for these properties in 2023. The other half are leases that just have fixed increases in rent over the course of the lease.

LaMonica: So, all of this seems pretty good. But we need to explore if we believe there is a sustainable competitive advantage or moat. And remember a sustainable competitive advantage means that there is some barrier to competitors to just copying their business model and stealing customers or driving down margin on the profit they make by undercutting them on pricing. Now surely with this huge portfolio of property with quality tenants there must be a moat. Is that true Shani? 

Jayamanne: No, it is not. We don’t believe there is a moat. And it is worth taking a step back here before we go into all the reasons, we don’t think there is a moat. Mark and I went to a conference the other week. 

LaMonica: The Australian Shareholders Association conference.

Jayamanne: Well, a couple came up to the booth after Mark’s presentation and was asking about moats and said that they understood how an analyst who had a full-time job could identify a moat, but they couldn’t see how they could do it. So maybe it will help to go through your answer to them, and then we can discuss CLW.

LaMonica: Well, what I said to them and will say to any listeners is that of course anyone can do this. It takes some work. It takes some study, but everyone can do this. And Warren Buffett famously said that to be a good investor you need to be a student of business. So, I asked this couple what business they were in. And it turns out they were chicken farmers. So, I said let’s look at the business you know well and figure out what would constitute a moat. And first I asked about barriers to entry. Because that is a sign there could be a moat. I asked what it took for somebody to become a chicken farmer. He said that you had to learn about chicken farming, and you need land and some equipment. But that basically anyone could do it and other farmers could add chicken farming operations to their property pretty easily. 

Jayamanne: So, if everyone decided they wanted to only eat chicken or eat more chicken and prices went up significantly more people would enter the chicken farming business. Temporarily these high prices would benefit the existing chicken farmers, but this would not be sustainable because there are not significant barriers of entry to chicken farming. 

LaMonica: Exactly Shani. And then I asked him about pricing power. What could he do to set chicken prices or have his chicken purchased at a higher price than competitors. He said that chicken was a commodity and the price that he could sell his chicken at was out of his control. He was a price taker which all commodity producers are. The only way to set pricing if you are a commodity producer is to either have a monopoly and control all the production or form a cartel and actively collude with other producers to manipulate pricing. 

Jayamanne: So, neither of those two conditions apply to chicken farming. 

LaMonica: They do not. The last high-level area you could have with chicken farming, or any business is a cost advantage. If you can’t control pricing and there are limited barriers of entry you could put yourself in a good position as a business if you can produce the same chicken as everyone else but for cheaper. You would then make more money by having a higher margin. Well, the only way to do this in chicken farming is to have immense scales but according to the conference attendee that is very hard to achieve. But we aren’t here to talk about chicken farming. We are here to talk about moats in real estate.

Jayamanne: So as Mark just demonstrated when he was talking about chicken farming the first step to identifying a moat is to really understand the dynamics of the industry and which moat source may be prevalent. Once you’ve done that you can look for evidence of a moat. So, we are talking about a company that owns real estate here. And we need to consider barriers to entry and pricing power and cost in our high-level assessment.

LaMonica: Well, there are very low barriers of entry for most real estate related companies. It is ultimately a really fragmented industry with all sorts of owners of commercial real estate, from private investors like super funds and insurance companies to wealthy individuals. And this is certainly the case for CLW.

Jayamanne: If we look at the retail, office and industrial property markets ownership is extremely fragmented which demonstrates how low the barriers to entry are. And particularly in office and retail there are some real structural headwinds in those spaces as more people work from home and office tenants look to shrink their footprint and in retail where COVID has moved a lot more shopping online. 

LaMonica: The other areas that CLW plays is the convenience space. And this is an area where Charter Hall and their associated entities like CLW are fairly dominant. But in saying that they control less than 10% of the market. And this is one space where supply keeps coming onto the market. Almost every new apartment building or transportation project has retail space associated with it meaning there is a constant influx of new supply.

Jayamanne: So, with low barriers to entry and a lack of unique assets there is ample opportunity for competition. The more choices a tenant has the more power they have over the rent they pay. This is why we don’t believe there is a moat. 

LaMonica: Moats in real estate typically occur if a company has a really unique set of assets that can’t be replicated by anyone else. We don’t believe that CLW has those unique assets. In the case of extremely unique assets, you would see the initial investment on those assets continue to compound as rents increase and the value of the assets increases. But since CLW doesn’t have a moat, they need to grow in other ways. And that gets us to our next consideration for real estate.

Jayamanne: There is one other aspect of real estate that is important to consider when looking at REITs. You hear a lot about investors searching for capital light businesses that are scalable. Let’s quickly go through these two concepts. When an investor says capital light or asset light it means that the preference is for a company that doesn’t need a lot of physical assets or constant investments in the business to support continued growth in revenue and earnings – that is scalability. We like that as investors because we don’t want the companies we own to have to keep investing in the business. We want that cash to instead go to us as shareholders.

LaMonica: That is why investors gravitate to companies that succeed based on intellectual capital. A software company that creates a product that can be sold again and again, and which is based on code that was created once. A pharmaceutical company that creates a treatment that can be sold to more and more people. That is scalability that doesn’t require a lot of investment for each new sale that is made. 

Jayamanne: And real estate is not that. You own a building that can only have a certain number of tenants. And while rent can grow over time if you really want to grow you need to build or buy another building. So, you may have good tenants, good lease terms but ultimately you need to invest for growth. And this is what Charter Hall WALE has done. In 2019 they made around $386m in acquisitions. $850m in 2020 and $626m in 2021.

LaMonica: And they’ve done that by borrowing money and issuing new shares. They’ve issued a significant number of new shares every year since 2016. And the share count has grown from 208 million shares to 720 million by March of 2022. And those share issuances dilute existing shareholders. If there are more shareholders, you own less of the company. Now that can benefit you as an investor if you own less of the overall pie, but that pie has significantly grown.

Jayamanne: And they also issued a fair amount of debt. If we look at net debt to assets CLW weighs in at 37% which our analyst acknowledges is high. Now while this is high CLW does have a relatively predictable earnings stream into the future because of those long lease terms.

LaMonica: But the problem with using debt and equity to fund growth is that it is very much based on economic conditions to continue to do that. You need investors to want to buy new shares and issuing debt is based on the expense of that debt – interest rates – and the markets wiliness to keep buying those bonds. 

Jayamanne: And in the current environment our analyst believes that funding growth through acquisitions is likely to drop significantly. And we believe that increased interest costs on the existing debt will start to weigh on earnings. In the next two years we believe that both earnings and dividends paid will actually drop. In 2022 the company earned and paid dividends of 30.5 cents a share. We expect that to drop to 28 cents per share in 2023 and 26.8 cents a share in 2024. 

LaMonica: And the other impact that the economic environment has on a company that has lots of assets is the value of the assets that they hold. And the assets that CLW holds are long-duration assets which is demonstrated by the long-lease terms that they have. Now with long-duration assets the level of interest rates has a significant impact on their valuations.

Jayamanne: We discount back future cash flows to value anything. Shares but also buildings. And when those cash flows go far out into the future that discount rate really matters. A lower discount rate means those cash flows generated by the assets are worth more. If the discount rate is higher those assets are worth less. And CLW has benefited significantly from ultra-low interest rates. 

LaMonica: But that of course is no longer the case. So that is another worry for CLW. But let’s get into the specifics about how our analyst sees this company. 

Jayamanne: We have a current fair value of $5.10. And with a fair value we want to build in a margin of safety. In other words, we want to account for the natural risk that comes from being the owner of a business by building in a buffer. 

LaMonica: And the more inherent risk in a company the bigger we want that margin of safety to be. Now in the case of CLW we believe there is only medium risk for all the reasons we outlined. Long leases, triple net leases where the tenant is responsible for maintenance and repair and good tenants all reduce risk.

Jayamanne: So, given that CLW was trading at $4.33 on June 5th, we see it as a four-star share which makes it undervalued in our eyes. But right on the cusp of being a three-star stock which we see as fairly valued.

LaMonica: And many REIT investors are looking to generate income and at the price of $4.33 it is trading for a dividend yield of 6.61%. Which is high but remember there are no franking credits and our analyst expects that dividend payment to go down in the coming years. 

Jayamanne: So today we covered a specific security, but we also wanted to help investors to think about any company they are evaluating. Just remember to give some thought to the business that the company is in and the underlying factors in that industry that can lead to sustainable competitive advantages and the factors that will impact the fortunes of that business.