The traditional model for investing in direct property is not broken, argues Dug Higgins. But watch out for debt
While the green shoots of economic recovery are valiantly emerging from the wreckage of the credit crisis (with no guarantee that they will not suffer some wilting), the short-term outlook for the unlisted property funds sector is not so sunny, given it has to ride out its own cycle.
While a lot of clinical post mortems have taken place in various sectors over the past 18 months or so, comparatively little has been done in the retail direct property funds space. The super funds have come under fire about their unlisted assets (of which direct property forms a part), but these assets don’t necessarily compare realistically to the retail funds. So perhaps the time has come for a quick look at the big issues going forward. And the biggest issue is always, arguably, the use of gearing. The direct property industry is being beset by several key dilemmas, such as syndicates maturing in a downturn just as the cost of financing begins to blow out; unlisted funds freezing investor redemptions; and loan-to-valuation ratio (LVR) covenants being tested (or breached) in both varieties of funds.
However, the main issue for the industry on an ongoing basis, as well as its current position from a structuring point of view, is still leverage. The questions being posed by many seem to be, firstly, “Is the syndicate/unlisted model broken?”, closely followed by, “What level of gearing is appropriate?”. The answer to the first question, we believe, is an emphatic “no”, but the second one is more complex. And as history keeps rudely reminding us, any good idea, if pushed too hard, can quickly turn into a painful scenario if the parameters are stretched too far. As Archimedes so famously claimed, “Give me a place to stand and a lever long enough and I will move the world.” This was perhaps a concept that when applied to the use of debt, if not taken too far, was certainly starting to be treated in an overly casual manner by the users of it.
The difficult task is to ensure that investors and their advisers recognise the changing landscape – as the nature of industries can transform relatively quickly from defensive into aggressive. As happened with the listed Australian Real Estate Investment Trusts (A-REITs), too many people failed to recognise that this historically defensive sector had largely changed into a highly leveraged play. Thus, they failed to see the change in the risk/return outlook. But where are the boundaries? How sensitive are modern unlisted vehicles to gearing? How safe is it? These are the issues that need to be firmly in the forefront of the minds of those contemplating such products. Each individual offering is subtly different from others, and their ability to withstand higher leverage also alters. Even so, a working knowledge of the basic boundaries is called for. And some differences between the events of today and events of earlier years need to be acknowledged.
Prior to the crash of the 1990s, unlisted property funds had lower levels of leverage (averaging 24 per cent in 1991) and more than half of the funds had no gearing at all, as a result of the high interest rate cycle at the time. Coming out of the downturn, however, property yields for the types of properties typically sought were double-digit, having declined during the crash. During the recession, the Reserve Bank of Australia (RBA) contributed by cutting rates by a sweeping 12.75 percentage points over three years, to reach a cash target of 5.25 per cent in early 2003. Therefore, even after adding in finance margins, a significant leverage advantage was created for investors, who derived strong income yields – the mainstay of returns from typical commercial property investment opportunities. So with unlisted fund assets yielding an average 10 per cent in 1991 and yields expanding further (as we see today), the introduction of the “return to basics” mantra – investing in pure unsophisticated real estate at a low point in the cycle without the issues surrounding liquidity and split trusts – undoubtedly looked attractive.
But in structuring funds, obviously the issue of leverage was critical in terms of what represented the most efficient level of gearing (with hopefully a contemporaneous amount of risk). While this obviously needs to be looked at on a case-by-case basis, depending on the nature of the asset, tenant, fund term and rent structure, if we use a fairly standard scenario of a simple property syndicate from the early 2000s, the leveraged outcome follows a predictable pattern. Obviously, with yields having a positive margin over interest rates, leverage compounds the level of achievable returns (the internal rate of return, or IRR). As gearing is increased, naturally the ability of a fund to cover the interest payable (the interest cover ratio, or ICR) narrows. In the chart on the left, the relationship between a trust’s gearing and returns versus its ability to cover interest is clearly seen.
Based on this example, we could suggest that a gearing level of around 50 per cent to 55 per cent represents a relative “sweet spot”. However, beyond 55 per cent the ICR begins to become uncomfortably thin, particularly if a volatile market is encountered. This, however, can be deceptive. Using the example above, if we viewed an ICR of two times as being an “acceptable” level of coverage, it could be argued that a gearing ratio of between 55 per cent and 60 per cent meets this target. However, this does not take into account the increasing sensitivity of leverage in the first place. If we examine the chart below, it illustrates the sensitivity of the ICR to movements in EBITDA (earnings before interest, tax, depreciation and amortisation), less the impact of unrealised gains or losses on asset valuations. Using the same data, a 25 per cent hit to EBITDA would keep a fund comfortably above the ICR of two times when gearing is at 40 per cent.
But at gearing of 50 per cent and 60 per cent, it starts to tighten up quickly. During the boom, very few funds experienced any serious hits to EBITDA, as strong demand and rental growth drove profitability. But today’s environment is a different story. Stagnating (and declining) effective rents, lower occupancy levels and higher finance costs have hit earnings heavily. For some funds, unfortunately, a 25 per cent fall in earnings would have looked attractive by comparison. What does this prove? In the broader sense, nothing at all, as it is based on a theoretical set of numbers that any one particular fund may or may not emulate. It also does not take into account the ability of the manager, the quality and drivers of the tenancy schedule or the structuring of the fund – all of which will have an impact on the ability of the vehicle to withstand financing pressures.
However, what it does show is that the higher you gear, the more watchful an investor has to be, and the greater the level of stress-testing required in judging the risks. The rise of the sector during the period from 2004 to early 2008 saw the use of leverage incrementally creep upward; and I suspect many failed to realise that a small rise from a high level has a much bigger impact than a big increase when starting from zero. In looking at this issue, in no way are we suggesting that the unlisted sector should abandon the use of leverage as a tool to drive returns.
Whole books could be devoted to the technical aspects of what represents the “right” level of gearing. However, what we are trying to do is heighten the understanding of the appropriateness of gearing to a fund, and the risk involved. The direct property industry has a solid track record of delivering strong risk-adjusted returns when structured appropriately. Current conditions are merely part of the investment cycle in what should always be treated as a long-term asset class designed to ride out the vagaries of investment markets. However, caution always needs to be applied in the use of debt, given its inherent ability to magnify both positive and negative outcomes.