Bunnings' other earner

In 1998, four years after its acquisition by Wesfarmers, the Bunnings Warehouse Property Trust was spun-off to focus on warehouse retailing properties and, in particular, Bunnings Warehouses leased to Bunnings Pty Ltd. It was listed on the stock exchange following the issue of 132 million ordinary fully paid $1 units.

The trust now owns 52 properties – 50 of them are established Bunnings Warehouse buildings, including warehouses in New Zealand after the acquisition of the Howard Smith group and the vast BBC network in 2001, as well as two distribution centres. Total assets have grown to $846.7 million with unit holders’ equity of $599.9 million after deducting total liabilities of $246.8 million, producing a gearing ratio (debt to total assets) of 25.9%, and the market capitalisation of the trust has grown to $660 million, almost a five-fold increase since initially listing.

Property

The first thing that should be immediately apparent from looking at the picture below is that properties owned by the Bunnings Warehouse Property Trust simply consist of a block of industrial land upon which a large shed/warehouse is erected and a car park built. This is a great business model.

Unlike property trusts such as the Macquarie Office Trust, which invest mainly in established buildings or constructing new office buildings on small amounts of land, each property in the Bunnings trust includes a significant land holding.

When it comes to property, what investors must understand is that the buildings themselves do not increase in value; it is the land that is annually revalued upward. The actual buildings depreciate over time to the point were they will become run-down and require refurbishment or need to be demolished and rebuilt. In the case of an office building, this can be a very costly exercise. It can take years to fully build a new office and be 100% occupied by tenants. Consider these facts for a minute;

It only takes approximately 22 weeks to design and construct each Bunnings Warehouse. A further six weeks are required to fit out and stock the store, at which point the owner fully occupies the building on a 10–15 year lease contract. The height of each Warehouse is equivalent to a three-storey building, with an under-roof area of about 8800 square metres – enough to fit 36 standard homes.

One would be hard pressed to match this 100% occupancy ratio, turn-around time and cost involved in the construction of a three-story office building entertaining the same area under-roof.

Better still, like a shed in the back yard, simply knocking it down and building another one is easy and relatively inexpensive.

Property trust performance

Over the past five years, units have risen from $1.25 to $2.13 and unit holders have been rewarded with an average annual compound return of 17.8%. This return includes unfranked distributed net income returns (no tax is paid on income received by the trust; all distributed income is taxed in the hands of unit holders) and capital growth from periodic property revaluations.

From a rental income perspective, leased properties owned by the trust are on long-term leases to Bunnings Pty Ltd and typically have a term of 10–15 years, followed by five-year option periods exercisable by the tenant. The lease income (rental income) received from the trust’s properties is currently reviewed annually in line with the consumer price index and is also matched to actual market increases every five years. At December 2006 the portfolio had an average lease expiry term of 8.5 years.

From a capital gain perspective, all properties owned by the trust are revalued periodically, with the entire portfolio revalued every three years to ensure properties held reflect their fair value. This can be seen in the above performance chart, which has performance spikes in 2004 and more recently in 2007 following the complete revaluation of all properties, which has produced net revaluation gains for the half-year of $94.3 million. These revaluations and additional acquisitions have contributed to an increase in the net tangible asset backing from 98¢ per unit in June 1999 to our $2.01 per unit estimate as at June 30, 2007.

After allowing for revaluations, net distributable income (100% of net income earned under this trust structure is required to be distributed to unit holders) has increased from $26.3 million in 2003 to a forecast $40 million in 2007. We are estimating a further small increase in revaluations for the remainder of the year. This represents a forecast yield of 6.2% at current market prices with capital growth potential from ongoing property revaluations.

Future prospects

Retailing through warehouse outlets is relatively new in Australia and the Bunnings Warehouse format is now well developed with a proven record of success. It is an area that has been very active in Australia over the last four to five years and currently accounts for nearly one-third of total retail sector completions.

Australia's per capita hardware consumption is one of the highest in the world, generating approximately $22 billion a year, with high levels of home ownership, large garden sizes, and dry weather conditions. Bunnings is the leading player in the home improvement market and, with such a large fragmented Australian hardware industry, it has significant growth opportunities.

Trust valuation

The current unit price is $2.13. Under my own stock valuation technique, Stockval, the trust assets are valued at $2.54, indicated by the circle on the graph below. This valuation is based on net tangible assets of $2.01, forecast sustainable return on equity of 14.5% and an investor’s pre-tax required return of 12.5%. Think about it like this: if you have $2.01 generating 14.5% annually and you are happy with a 12.5% return, you can pay around 1.26 times equity for that $2.01, or $2.54. The market is therefore expecting much lower rates of return on equity (and we have been conservative in adopting 14.5% judging from past performance) or is requiring a return greater than 12.5% for a property trust that has a wonderful track record and excellent future prospects.

Roger Montgomery, is managing director of Clime Asset Management, an investment company.