McGrath float and sink bodes ill for Australian real estate

With talk of an Australian property bubble ramping up, few businesses stand more exposed than the nation's real estate agents.

One of the east coast's major players, McGrath, listed on the ASX in December and, if its share price since is any indication, Australian real estate is in trouble.

After listing at $2.10, the stock has lost more than a third of its value in just three months.

That does not surprise fund manager Roger Montgomery, who passed on the opportunity to buy in.

"When we're investing in a float we're looking for two things - we're looking for quality and we're looking for value," he told ABC TV's The Business program.

"For us, neither of those things, to the standard that we expect, were present in McGrath."

It is not that Mr Montgomery believes that real estate agencies are fundamentally a bad business.

Quite the opposite, with relatively low overheads and the potential for high profit margins, the fund manager believes they are a great investment ... at the right price and the right time.

Property 'in line for a correction', market pricing 30pc drop

However, Mr Montgomery points to record Sydney home prices - which have jumped 50 per cent in just the past three years - and record dwelling construction, especially apartments, as a risky combination.

"Wherever there's been an oversupply the prices have subsequently fallen and agents are in the firing line when property prices go down," he cautioned.

"We see a proliferation of real estate agents and new brands emerge during a property boom and we see them all wind up and consolidate again when the market comes off.

"And we think we're in line for a correction in property prices."

That has led Montgomery Investment Management to a valuation which suggests the pain is far from over for McGrath shareholders.

"It was around a dollar, rather than two dollars," he said.

"That was partly because of our assessment of the future, not just the company's performance to date."

Chris Savage from brokerage Bell Potter, which helped manage McGrath's float, is much more upbeat, valuing the company at $2.25.

He acknowledged that McGrath's profitability is extremely leveraged to the health of the east coast property market, and his positive outlook for the company is based on a more sanguine view of the prospects for Australian real estate.

"The share price is about 30 to 40 per cent below my valuation and about 30 to 40 per cent below where the IPO price was so, in very rough terms, you could argue that the market's anticipating a 30 to 40 per cent drop in the property market," he told The Business.

"Personally, I'm anticipating relatively flat volumes and pricing going forward for the short to medium term, and that's factored into obviously my forecast and valuation."

However, the principal of Parramatta-based real estate agency Just Think, Edwin Almeida, said the downturn Roger Montgomery warns of is already hitting western Sydney.

"We've identified some areas were properties have already actually gone backwards by anywhere between 8 and 15 per cent," he told The Business.

"Asking prices are dramatically being pulled back, in some parts of Sydney by up to 20 per cent."

Agents hit several ways by slowing property market

Not only does that mean reduced commissions, Mr Almeida said it also means a much longer wait for agents to get that cash as properties sit on the market for months instead of weeks.

"We're moving from 21 days, where you could almost be guaranteed an income from the sale of the property within three months, within 10 weeks you'd have money in the bank," he said.

"Now we're going possibly into even a five, six month period before we actually get paid."

Transaction volumes are also a key concern for agents and, while they may rise with forced or panic sales during a bust, Mr Almeida said clients tend to shift agents more often in a falling market where they cannot get the price they want.

"Just because you sold a hundred last month doesn't mean that you're gonna sell a hundred this month," he warned.

"It's all relative and it's all going to be controlled by market forces outside of the business."

That is why, in his other role as a business broker selling real estate agencies, Mr Almeida virtually ignores sales commissions when valuing a business.

"When I go and value a real estate office that's for sale we're actually placing most of the value - 90 per cent of the value - on the rent roll, 10 per cent would be the goods and chattels," he said.

"The rent roll is the properties that we manage for investors, for landlords, that gives us our bread and butter."

Mr Almeida said real estate agents collect about 5 per cent of rents as their fee for managing the properties, and this is their most stable source of income.

In McGrath's prospectus, the rent roll held by company-owned agencies made up only 11 per cent of pre-tax and interest profits (EBITDA), while sales commissions from company-owned agencies were 71 per cent of the firm's profits.

McGrath made 14 per cent of its financial year 2016 income through franchise fees from its non-company-owned offices.

That heavy reliance on sales commissions from company-owned offices leaves McGrath's earnings heavily exposed to fluctuations in the Sydney and south-east Queensland property markets.

Estate agent selling own business a 'red flag'

However, John McGrath and his co-owners would not be too concerned.

On Roger Montgomery's company valuation of a dollar per share, they have already realised most of the business' value in cash, while still retaining ownership of almost half of the listed firm.

Out of nearly $130 million raised in the float, about half was used to partially buy out McGrath's existing owners; another $31 million went to buy out the Smollen Group of McGrath franchises; $16 million paid off existing debts and $10 million covered float costs; that left only $8 million as working capital.

"So you haven't got much firepower to actually go and buy more practices if you really do want to expand," noted Mr Montgomery.

None of this should surprise shareholders - it was all clearly laid out in black-and-white in the prospectus.

Mr Savage also pointed out that the new share market-listed structure, growing cash reserves and lack of existing debt gives McGrath room to quickly raise money for takeovers.

"The cash increased to over $10 million at the half, so I think it's now about $13, $14 million," he said.

"Acquisitions can be funded by both cash and scrip, which is one of the reasons why I think McGrath wanted to list ... and they've also got a debt facility available, so put those three together and I think you've got sufficient funds for them to pursue acquisitions."

Whether the optimists are right and McGrath is currently undervalued on the basis of unfounded property bubble fears, or the pessimists are correct and worse is to come for its share price, after building his business from a single Sydney agency to over 80 in a network across NSW, Queensland, Victoria and the ACT, who can blame McGrath for cashing in.

However, Roger Montgomery is convinced the McGrath float is another cautionary tale of buying into IPOs when private owners are selling.

"When a highly knowledgeable, skilled and successful real estate agent is selling down their own exposure to their business, that for us is a red flag," he concluded.

Perhaps it should also be a red flag for those who steadfastly believe Australian property prices cannot crash.