Dug Higgins says it will still pay to remain cautious and seek out property investment opportunities with care.
As mid-2011 approaches we are starting to see some encouraging signs of life from the property funds sector. The A-REITs and associated property securities funds have been able to post some good gains as the listed side reclaims lost ground. Fund managers have largely stabilised balance sheets and are now looking for continuing benefits from improving real estate fundamentals.
By contrast, however, the retail level unlisted property funds landscape remains littered with casualties. While a small number of funds have managed to escape unscathed, particularly open-ended trusts, many are still in extremis weighed down by high-cost debt and stagnant asset valuations. Indeed, as highlighted by us during 2009 and 2010, those funds with second-tier assets have taken a long time to touch bottom and some portfolios continue to post negative gains, based on their latest valuations. With many funds continuing to freeze both redemptions and payment of distributions, the short-term outlook continues to be inclement for a large chunk of the industry.
While the picture for some still looks grim from a workout position, this does not mean that the sector is a total write-off. Some of the newer funds, launched since 2009, will take advantage of cyclically low asset values and lock in solid performance as the cycle moves. Notwithstanding the high cost of debt, there have been some excellent buying opportunities out there. However, we remain cautious about the sector at large as the quality of some newer offerings leaves a lot to be desired. This is not because we see fault lines appearing in the commercial property market (although some segments are riskier than others); rather, this is because we see a distressing number of funds out there whose investment merit is largely absent.
While cyclical downturns often present the opportunity to find bargains, investors should not forget the hard lessons re-learnt from the latest slump. Regrettably, some of the practices and structural issues common during the boom have survived to haunt today’s offerings – so advisers should remain exceedingly cautious and be prepared to have a good look at what lies beneath some of the glossy offerings of today. A downturn provides opportunities – but just because an opportunity exists does not mean it should be chased with abandon.
The most common issue is management. We argue unashamedly that when taken as a whole, there are comparatively few high-quality investment managers in the retail unlisted property funds space. Since 2009, there have been 95 attempted capital raisings in this sector from 40 different managers. These have encompassed a variety of investment strategies and property classes, spanning new funds as well as raisings by existing vehicles (usually in an attempt to recapitalise). Of these 40 groups we consider only six to have been sufficiently high-calibre real estate fund managers offering investment grade products during that period.
As a rule we tend to favour managers who are of institutional quality, whose wider businesses in part involve either the operation of A-REITs or wholesale unlisted funds for institutional investors, and who have operated through full real estate cycles. We also prefer to see managers who have gone through a cycle of both prudent acquisition and divestment of assets. This by no means categorically rules out smaller boutique players in the market. However, when contemplating using these funds, a significantly greater level of due diligence needs to be undertaken as to their abilities, capacity and stability going forward. In particular, the recent influx of new entities promoting their “lack of legacy issues” should not be confused with the presence of talent.
Secondly, the use of excessive or imprudent levels of leverage remains with us. While the level of debt that lenders are prepared to put forward has understandably shrunk – along with the general appetite of discerning investors for such practices – we still see some new funds attempting to leverage at levels beyond 55 per cent. While this is often “justified” as being less risky after a downturn in asset value, the equation is not that simple. At the very least it must be remembered that while leverage cannot make a bad investment good, it can certainly turn a good investment bad. Generally speaking, once leverage in commercial assets passes 50 per cent, the risk increases exponentially over a long timeframe.
While the metrics of this simplified calculation can be stretched somewhat – depending on asset quality, strategy, management calibre and interest rates – leverage tolerances are narrow. Zenith prefers gearing to be less than 50 per cent and would regard numbers less than 30 per cent as conservative. The alternative way to look at it is having an interest coverage ratio greater than two times for a wide moat of safety.
The current reversion to closed-ended vehicles, in response to market aversion regarding frozen funds, brings another problem. The majority of recent syndicate raisings have been for a single asset – driven by the fact that it’s currently difficult to raise the capital required for multi-asset portfolios. As a broad-brush approach, to make for a strong investment opportunity from the portfolio perspective, you either need a single asset of unassailable quality (although it’s hard to eliminate risk entirely) or a sufficiently diversified portfolio to mitigate risks on a basket of comparatively lower-quality assets.
