Going direct with property

Damon Taylor writes that the pursuit of yield has seen renewed interest in property funds but that investors need to consider the whole cycle. 

In what many predict will be a lower, slower growth world, it is becoming increasingly apparent that super fund investors are looking for something different within their portfolios.  

Where a certain degree of risk and volatility may previously have been tolerable, yield and stability have now come to the fore and according to Jason Huljich, Chief Executive Officer of Centuria Property Funds, so too have the defining characteristics of property.  

“So what we’ve seen in the last 12 months is a huge demand from investors for unlisted property investments,” he said. “As term deposit rates have dropped down, usually below 5 per cent, we’ve seen a significant uplift in demand for our funds and that, quite simply, is because people are looking for yield.”  

“So we setup 3 funds last year, returning in the 8 to 9 per cent range, which is obviously pretty good arbitrage with respect to the term deposit rate but what’s been obvious is that all sectors have performed strongly,” Huljich continued. “Industrial’s been performing strongly, as has office, and even in retail the demand has come back, especially for well-located neighbourhood centres.” 

“Its been a very solid year leading up to now but the big thing is trying to find value in the current market because its actually really tough.” 

Giving a performance report card for listed and unlisted property in combination, Steven Leigh, Managing Director of QIC Global Real Estate, said that listed property had actually outperformed in the 5 years post the global financial crisis (GFC). 

“And that is largely consistent with how the broader share market has performed,” he said. “Its a function of the asset reflation policies of central banks globally as policy makers depleted their fiscal reserves in combating the more pernicious fallouts of the GFC and were left solely with monetary tools.”   

“As the 2004-2007 A-REIT run up showed, such short-term performance unwinds, particularly if it isn’t supported by fundamentals,” Leigh continued. “So we believe a 10-year or 15-year horizon is more meaningful in order to adequately measure the performance across a full property cycle (both up and down market).” 

Within unlisted property, Leigh - like Huljich - said that most sectors had performed broadly in line with investor expectations.   

“However, one must also consider the different risks associated with the various property exposures,” he said. “On a risk-adjusted basis, the reasons why an increasing number of super funds have shifted their property allocation preference in favour of unlisted property becomes clearer.”  

“In terms of current opportunities, we currently see very limited, if any, return-accretive opportunities in terms of purchasing existing assets in the market place,” Leigh added. “Most deals that come across our table today are unable to satisfactorily compensate our clients for the risk they are undertaking due to lower expected returns resulting from strong yield compression as asset values rise.” 

“Fortunately, QIC can activate its asset creation pipeline where we currently see more opportunity to add value to clients’ funds.”  

Yet while the stable nature of property means that it has become an investment staple for a number of super funds, both the GFC and market evolution has meant that the asset class has changed significantly.  

Indeed when asked how super funds’ current treatment of property differed as compared with 10 years ago, Leigh was quick to point out that while funds’ use of the asset class had undoubtedly changed, they continued to seek similar outcomes. 

“No matter how much time passes, super funds still want access to the same valuable underlying characteristics of core property investments,” he said. “The fact that its defensive, that it can generate returns with low volatility underpinned by steady and dependable income streams, providing partial inflation hedging and diversification within a multi-asset portfolio.” 

“But investors have also become more discerning as to how they structure their property investments,” Leigh added. “Larger super funds have clearly shifted in favour of direct investments with greater investor control either as a separate account or a joint venture or a small club of like-minded investors.”  

“Alternatively, medium to small funds continue to access property directly through unlisted wholesale funds and/or listed A-REITs but even then, investors have come to expect more contemporary terms and conditions which provide greater transparency, governance and accountability from their managers.” 

However for Leigh, other changes within the property asset class, particularly around its makeup, were largely due to investors’ experiences during the GFC. 

“Broadly speaking LPTs (listed property trusts), as the A-REITs were then known, made up approximately 60 per cent of the institutional investment universe 10 years ago compared to about 40 per cent for unlisted wholesale funds,” he said. “Today, that ratio has shifted closer to 50:50 with investors preferring unlisted property, where possible, to diversify the equity risk in their multi-asset portfolio.”  

“But this is in line with a broader post-GFC shift to reduce the listed equity exposure of Australian institutions (amongst the highest in the world at that time) by increasing exposure to alternatives such as property, infrastructure and other unlisted asset classes,” Leigh continued. “And similar trends can be seen internationally - in a recent survey by Preqin of 380 institutions globally, 30 per cent indicated plans to grow their real estate exposure, 53 per cent thought it likely that their exposure would remain unchanged and only 18 per cent planned to decrease their capital commitments over the next 12 months compared to the past 12 months.” 

“Over the longer term, 41 per cent planned to increase property allocations, with 52 per cent unchanged and a mere 7 per cent intending to reduce exposure.”  

Offering a sightly different perspective on how the property asset class had changed in the last 10 years, Huljich said that one could not underestimate the impact of foreign capital entering the Australian market. 

“The sheer volume of offshore buyers coming back in has been a huge change over the last few years, on the resi development side in the first instance but also on the commercial side,” he said. “On the development side, it’s mainly been the Asian groups but on the investment side, we’re seeing all nationalities coming in and looking to buy into Australia.”   

“And I guess that’s largely due the yield differential between Australia and what you might call the gateway cities,” Huljich continued. “If you look at Singapore or Hong Kong, where you might be getting 3 to 4 per cent, and then Sydney which has been getting 7’s, Australia has been quite an attractive proposition for these offshore groups, particularly if they don’t have to hedge.” 

But irrespective of foreign interest and local shifts between listed and unlisted exposure, Ryan Banting,  Head of Portfolio Management for Australian Unity Real Estate Investment, said that the bottom line was that super funds continued to enjoy a good relationship with property. 

“Property provides a very attractive and very stable income distribution,” he said. “Its tax effective in a lot of cases and it acts as a relatively good inflationary hedge as well.”  

“So a lot of the traditional reasons that investors like property remain,” Banting continued. “For me, what’s changed is the filter through which investors are viewing all investments, not just property.” 

According to Banting, retail investors and institutional investors alike had shifted from a dynamic view of asset allocation to a more strategic view and property investment had benefited as a consequence. 

“So rather than a dynamic view of asset allocation, which warrants a greater consideration of liquidity, investors (particularly retiree investors) are starting to take a much more strategic view of their asset allocation,” he said. “And in that strategic view, they’re happy to trade off liquidity and that’s a key difference between what was taking place 10 years ago and what is taking place now.” 

“With a dynamic view, they just aren’t able to pick up the same kind of yield in fixed income or cash investments that they are in property investments,” Banting continued. “So I think investors, particularly those that are moving into retirement or even some of the larger pension funds, are starting to increase their exposure to both real estate and infrastructure as higher yielding investments and trade off some of the liquidity that these investments may provide.” 

“And they’re willing to do that because it provides them with access to a yield that they’re not necessarily getting from their traditional sectors, being cash and fixed income.” 

So in light of post-GFC learnings, altered investment philosophies and investment markets in which growth opportunities will be few and far between, Leigh said that property was well placed. 

“At QIC, we see property continuing to play an important role in multi-asset portfolios, especially in a lower, slower growth world,” he said. “The challenge in that sort of environment is that the cost of essential items (eg. healthcare, utilities, education) continues to outpace CPI (consumer price index) which, in turn, is running faster than average wage growth.” 

“In a world where real wages are falling, it is doubly important to have inflation-hedging assets classes, like property, to help maintain the purchasing power of retirement nest eggs,” Leigh continued. “Moreover, with the Baby Boomer generation starting to retire and draw down on their retirement savings, the need for steady, reliable income steams which core property delivers will only grow over time.” 

Adding weight to Leigh’s sentiments, Banting said that investors could expect to see a continuation of the themes they’d become used to over the next 12 months. Indeed for Banting, the weight of foreign capital entering the Australian property market was almost certainly a new normal. 

“While I’m not sure that there’ll be any substantial increase, I suspect foreign investment will maintain its current level for some time to come,” he said. “If we said that FY13 yielded about $3.5 billion of foreign investment and FY14 was about $6 billion, then I think somewhere between $4 billion and $6 billion is likely for the next 12 months.” 

“So thats going to continue to make property acquisitions quite competitive and, as a result, we’re going to start to see capitalisation rates continue to come in - probably not sharply - but over the course of the next 12 months, perhaps 20 to 25 basis points.” 

However, for Banting, investors needed to remember that such moves were likely to be in the face of softer tenant demand for CBD office space combined with softer retail demand on the back of increased unemployment. 

“But in early 2015, we feel those markets are likely to start to pick up as consumers start to become a little more confident and start to contribute to economic growth,” he said. “Consumption will lead that but it will also come about as businesses continue to be considerably supported by stimulatory legislation in terms of company tax rates as well as very easy monetary policy, which will more than likely continue for the medium term.” 

“So with that in sight, we see property will continue to provide some modest capital growth over the next 12 months and a continued stable level of income.”