Dug Higgins looks at just where direct property fits into the investment jigsaw.
The unlisted property funds sector has been hard hit by the events that have unfolded over the past two-and-a-half years. While a large number of funds – and their investors – have suffered as a result, the investment class retains merit, as long as certain ground rules are taken into account.
The current climate could also be considered a trigger for investing in this asset class, based on improving real estate fundamentals. While not without risks, current fundamentals are moving in the right direction as the cycle turns. Each investment opportunity needs to be judged on its merits, but we consider that direct property as an asset class retains significant merit when used appropriately as part of a diversified portfolio. At its simplest, real estate can be bought either directly by an investor (direct ownership) or via an investment fund.
Property-based investment funds can be divided into three main categories:
- Direct investment vehicles: The vehicle purchases and holds the asset(s);
- Indirect investment vehicles: The vehicle invests only into other direct vehicles which purchase and hold assets, but does not purchase assets in its own right; or
- Hybrid vehicles: The fund has a combination of both direct and indirect exposure to assets.
In this article, we will focus on direct investment vehicles only – specifically, property syndicates and unlisted property trusts. Generally, each investment vehicle tends to have distinct attributes regarding asset strategies, structures, leverage and liquidity. This will affect investment decisions and portfolio allocation. It is also important to understand that each type of vehicle may use different performance benchmarks and that these benchmarks must not be confused.
where does it fit in?
Property is generally considered to be a medium- risk asset class – but this is directly related to the structure of the investment used. When taking into account the range of investment strategies and vehicles available, the assessment of risk can range from medium to high, compared to other asset classes, depending on leverage, portfolio composition, management strategy and structure.
Why commercial real estate?
Commercial real estate, as an asset class, has several key attributes that make it potentially attractive to investors as part of a diversified portfolio.
defensive and growth attributes
Asset classes are generally classified as being either defensive (cash and fixed interest) or growth (equities and alternatives). Real estate tends to have both defensive and growth attributes. It comprises solid, income-producing assets – when supported by quality buildings with strong tenants on medium- to long-term leases – and generally shows lower levels of volatility in capital returns than other asset classes. However, depending on the investment strategy used, real estate can be structured to be more or less defensive or growth in nature. It should also be appreciated that valuation lags tend to have a smoothing effect on capital returns volatility.
Low volatility of income
Commercial real estate as an asset class generally follows the rule of thumb that most of the total return (about two-thirds) comes from income, and the rest from capital gains. Direct ownership of real estate over the long term has proven that while capital values fluctuate on a cyclical basis, income returns show very low levels of volatility. It is in the order of less than 1 per cent per annum, as an asset class, according to the Property Council of Australia and Atchison Consultants.
While the income returns over time show an impressive level of stability, it must be remembered that this data takes into account a very large number of properties, real estate asset classes, regions and tenants. The ability of an individual to invest into real estate on the same basis is virtually impossible, although vehicles with very large diverse portfolios may be regarded as a proxy.
Over the long term, total returns from real estate are competitive with those from other asset classes, particularly when accounted for on a risk-adjusted basis. While the data does not fully account for the impact of the decline in property values, which began to bottom in late 2009, the total return calculated for property does include the effect of the property downturn of the early 1990s, which was more severe in terms of falls in asset values than that experienced post 2007.
property lowers volatility
Given the nature of low-volatility income streams generated by quality, stabilised real estate, an allocation to direct property lowers volatility within a portfolio. Real estate provides an effective way of accessing assets with low or negative correlation, even compared to A-REITs, over the longer term. This highlights that listed property tends to be a weak proxy for direct real estate investment in some situations. While investors need to be conscious of periodic shifts in correlations (such as those experienced between listed property and equities during the latter half of the decade), overall, direct property provides an effective way to lower risk.
Direct vs investment vehicles
While real estate as an asset class has lots of compelling attributes, the risks and limitations associated with unlisted direct property funds must be appreciated. Because of the way asset class performance is measured, unlisted direct property funds generally cannot diversify enough to closely replicate these attributes, due to the high cost of acquisition and illiquidity. As such, prospective investors in unlisted funds must take care that investment funds present an appropriate risk/ return trade-off.
Is now the time to invest ?
As with all investment cycles, human behaviour tends to rule much of the decision- making process, unless sentiment is removed from the equation and logic applied. Having been dragged through a significant period of wealth destruction across multiple asset classes, investors have typically (and understandably) reverted to being extremely risk-averse. While this is a natural phenomenon, this should not ideally be at the expense of forgoing periods where cyclical opportunities present themselves. Looking at the market cycle, 2009 largely represented the slide to the bottom of the sentiment cycle for unlisted real estate investors.
The early adopters – the private investors and highnet- worth individuals – have already moved into the real estate market during 2009 and cherrypicked assets where they could see mispricing and counter-cyclical opportunities. We are currently at a point where opportunities are likely to come up, and retail investors should take advantage of those that adhere to sound investment principles. As measured by the PCA/IPD Australia Property Index, the market commenced bottoming out in late 2009 and the recovery phase has been initiated. It is apparent at this stage that the pace of the recovery is shaping up to be faster than that experienced in the early 1990s, when a significant overhang of commercial stock dragged out the recovery.
The unlisted direct property funds sector is now arguably split into two main segments, in terms of investment opportunities. Firstly, there are those existing open-ended funds that have borne the brunt of the credit crisis and the decline in asset values and are facing a bumpy road to recovery. Some will eventually recover and others will not make it. Opportunities exist, but are relatively few at this point. There will also be a large number of closedend property syndicates due to mature shortly – but whether or not these will provide investment opportunities is difficult to determine in advance. Secondly, there is a range of newer funds, launched from mid-2009 onwards – both openended trusts and closed-end syndicates – which should be able to capitalise on the correction in asset values.
However, care will need to be taken with issues such as potentially untested new entities and management groups; cost of financing; and the prospects for individual property markets. Zenith reiterates that investors should be strongly discerning in investment selection, as this is a sector that poses significant threats when structured poorly. But if it’s all done properly, the rewards are certainly worthwhile. The key risks and issues which need to be considered going forward are:
- The strength and timeframe of the real estate recovery, which is predicated on broader economic drivers, both domestic and global;
- The short- to medium-term financing costs and debt availability for the sector;
- The implications of significant amounts of debt refinancing faced by the sector in the next one to two years as a result of short-term rollovers in 2008-2009;
- Determination of a prudent use of leverage in a vehicle; and
- A realistic assessment of liquidity in openended funds and its implications.
While the sector recovery is not without risk, and any investment opportunities must be approached with careful planning and assessment, Zenith believes that the unlisted direct property sector retains merit when participating with strong management, appropriate structures, prudent leverage and quality assets. Despite the inherent qualities and attributes offered by exposure to real estate as an asset class, history continues to teach us that the acquisition of quality assets cannot compensate for poor investment structures or inappropriate decision-making. When enacted prudently and when taking advantage of cyclical opportunities, however, the rewards are well worthwhile.