Kelly Napier says the past few years have taught us some lessons about assessing the merits of direct property investments. Here’s her handy checklist.
Property fund investors have coped with great challenges over the past two to three years, and there’s no doubt that investment flows into unlisted direct-property funds have subsided from the heights of the mid-2000s. As the global financial crisis unfolded, practices adopted by some direct-property fund managers came horribly unstuck and exacerbated reductions in the value of unlisted property fund investors’ equity.
It now seems that investors are beginning to warm to the possibility of reconsidering direct property for inclusion in their overall investment portfolio. In light of investors’ renewed appetite, Standard & Poor’s Fund Services has prepared a list of what it considers to be the 10 most important characteristics of strong core property fund investment offers.
We believe that these points should be “front of mind” for investors and their advisers when considering an allocation to direct property, and subsequently when assessing the merits of particular core direct-property investment opportunities. In addition to the points listed below, we encourage investors to look for sustainable and transparent investment structures, which deliver property returns – not the unsustainable, engineered, or structured returns of the past.
Overall, funds which are moderately geared, with sound underlying property portfolios, which are able to generate sustainable, consistent income and scope for capital growth over the long term are the most attractive. The idea of fund managers “going back to basics” is a great way to rebuild trust and regain investors’ confidence as they try to put some distance between the old and the new; to demonstrate to investors the lessons learnt from the past few years, and to ensure better alignment of interests with investors.
1. Be realistic
An investment in direct property can deliver regular income based on contracted leases; provide an inflation hedge, the opportunity for capital growth; access to a diversified pool of institutional-grade property, specialist management; and scope to reduce overall portfolio volatility.
Provided investors have a minimum five-year investment horizon, direct-property investment can be an attractive proposition. If you’re expecting something different, then direct property probably isn’t for you.
2. Quality management
There are many “professional” managers out there, but we have found that they’re not all of the same calibre.
The manager has an important function and has a strong influence on overall performance, so look for fund managers with a strong reputation, and experienced and stable investment management teams who have gathered their experience across market cycles. Often the team can present a competitive edge and truly add value for investors. Appropriate remuneration structures and incentives provide for a strong alignment of interests.
3. Prudent gearing
Experienced investors in direct property know all too well that gearing magnifies changes in total returns – on the way up and on the way down.
The appropriate level of gearing will depend on the stage in the credit and property cycle. Look for headroom below banking covenants (loan-to-value ratios and interest-coverage ratios) so that the fund can withstand gaps in income and falls in valuations without breaching covenants. Be wary of funds geared too close to covenants at the peak of the property market cycle.
4. Headline yield
Historically, investors and advisers became accustomed to seeing attractive double-digit returns comprising a distribution yield often exceeding 8 per cent per year.
But investors need to look past the headline yield to see the underlying assets and what a fair return should be. The distribution yield is a function of many inter-related inputs which vary at different points in time and include: property yield, management costs and expenses, gearing levels, and the cost of funding. Direct-property funds are known for their stability of distributions, but there shouldn’t be any unsustainable support or upward pressure brought to bear on distribution yields when the underlying investments can’t meet those expectations.
5. Distribution policies
After examining the headline yield, investors should understand the composition and source of the distribution.
Distributions should only comprise net income and realised capital gains. In the past, some fund managers engaged in the practice of supporting lower income distributions with a component of unrealised capital gains. These represented a partial payment of increases in capital value which were often debt funded. This only served to increase the risks to investors as capitalisation rates expanded, asset values fell, and bank covenants were approached or exceeded.
6. Risk-return proposition
Investors should be clear about the asset-specific risks (tenant risk, likelihood of vacancies, tenant demand, potential obsolescence, capital expenditure requirements, asset quality, location, and growth potential), debt risk (not just the level of gearing but its cost, maturity date, and associated covenants), key person risk, development risk, and liquidity risk.
Many risks are difficult to quantify as they are qualitative in nature, but investors should be compensated for the risks they are taking on. That is, they should receive an appropriate premium or hurdle over a risk-free rate. Due to the positive relationship between risk and return, the caveat is not to be blinded by the return side of the equation but to ask what risks am I taking on and am I being appropriately rewarded?
7. Liquidity
Investors should approach direct property with a minimum investment horizon of five years.
Property assets are inherently illiquid and cannot be readily converted to cash, so immediate access to capital shouldn’t be expected. If a fund is offering access to capital it’s very important to understand the redemption terms and the conditions under which access can be varied, suspended, or terminated.
8. Conflicts of interest
Conflicts of interest are rarely absent in direct-property funds management, given the evolution of the industry from property development/ownership into property funds management.
However, these can be prudently managed by proven professional and ethical management, supported by thorough documented policies and procedures and independent risk oversight.
9. Conservative assumptions
It is important to make sure that fund managers are firmly grounded in reality and don’t have impossibly optimistic objectives.
Markets move in cycles, debt costs change (margins and base rates), vacancy rates aren’t constant, asset values can rise or fall, capital expenditure needs to be funded somehow, and demand and supply for space aren’t constantly in favour of property owners – so incentives and let-up periods need to be factored into budgets. Assumptions need to be reasonable and have a sound basis for being adopted. No-one wins when an investment manager over-promises and under-delivers – least of all investors.
10. Fees
Upfront and ongoing costs could be hefty and significantly affect the return over the investment period. Fees can include fund establishment costs, asset acquisition costs, debt establishment fees, asset disposal fees, and annual management fees and costs. Performance fees shouldn’t be overlooked and can also be significant. Performance fees should be based on an appropriate benchmark or premium over a risk-free rate, which reflects the risk of the investment, rather than an arbitrary hurdle that could easily be achieved without the manager truly “working” the portfolio.
Kelly Napier is an associate of Standard & Poor’s.
