Are REITs still a worthwhile asset class?

REITs are worth persevering with as an asset class, even if allocations within a portfolio are low for the time being, according to Tim Farrelly.

Are real estate investment trusts (REITs) still a worthwhile asset class?

This is a very good question, and one we get asked regularly.

The reasons put forward as to why not to focus on REITs as a separate asset class are many and include:

• They seem to behave like equities, not property;
• The index is dominated by one name – Westfield;
• There is very little diversification, with a few entities dominating the index;
• It is virtually all retail, and retail is dead because of online shopping;
• The expected returns aren’t attractive either; and,
• The farrelly’s allocations are too low to make any difference.

A glance at Figure 1 showing Australian REIT (AREIT) price movements over the last two years would seem to suggest the patient is dead – certainly if this was a heart monitor chart, that would be the conclusion.

Despite this, REITs are worth persevering with as an asset class, even if allocations within a portfolio are low for the time being. 

What makes a worthwhile asset class? Farrelly’s criteria for a assessing whether an asset class is worthwhile are predictability, investability and differentiation. REITs tick all three boxes.

Predictability

REITs are quite predictable over the long term. Rents grow at around inflation, and valuation multiples are mean reverting.

The shocks over the past few years highlight the risks that exist with all forecasts – sometimes they can be wrong, particularly if the fundamentals shift dramatically and unexpectedly.

In the case of the recent debacle, the villain of the piece was excessive gearing and abysmal management of that gearing. The difficult-to-predict aspect was just how much damage that poor management could inflict. Now we know.

Investing is easy

Investing in REITs is simple. Managed funds, exchange-traded funds and direct investment are all straightforward in big amounts and small.

While farrelly’s would prefer to invest in property directly or by way of unlisted vehicles, the investability criterion is difficult to meet.

Illiquidity, excessive gearing, excessive fees and too lumpy sizes all make direct unlisted investment difficult.

And, given the long-term return profile of direct investment is not that different from the listed alternative, we remain happy to stick with the listed vehicle.

REITs are different

The fact that the question as to whether REITs are a worthwhile asset class is being asked is evidence of how different they are. Right now, Australian equities look a far more attractive proposition than AREITs.

On the other hand, AREITs looked more attractive than equities from around 1998 through to 2004. During the period 2000 to 2007, AREITs outperformed equities; since then, equities have greatly outperformed. AREITs do march to a different drum.

They have become highly correlated with equities in the short term, which gives rise to the feeling that they seem to behave just like equities.

However, in the short term, most assets are positively correlated, so if taken to its logical conclusion, this argument would have us with just two asset classes; equities and debt.

For our purposes the main question is: are they different in the long term? The answer is clearly yes.

Are AREITs too undiversified to represent a viable asset class?

This is another tricky question, and one ultimately dominated by a discussion of gearing. AREITs have been variously reported to own somewhere between 30 per cent and 50 per cent of the total investment grade property in Australia.

On this basis, it is clear that buying the index of AREITs gives an incredibly diversified exposure to Australian commercial property. The index is clearly not undiversified from a property perspective.

Excessive exposure to retail property?

This seems to be a bit of a furphy. Retail property is probably the most resilient of all the main commercial property categories, and so a higher exposure to that is like having a corporate bond fund with an excessive exposure to AAA-rated companies.

It will not help your long-run returns but may not actually increase risk.

Excessive manager concentration

This is another furphy. The real issue is more about whether having that property in too few hands creates another set of risks.

The two Westfield funds plus Stockland and GPT represent almost 60 per cent of the index. Throw in Goodman and Dexus and we are at over 70 per cent of the index, with half of that represented by the two Westfield entities.

This represents a concentration of management rather than a concentration of too few underlying properties. Do we need management diversification? Maybe.

Given the appalling track record of the industry in managing debt, it could be argued that the answer is a categorical ‘yes’. We disagree.

The problem with excessive debt is that all the managers tend to take it on at the same time, driven by the same factors. Manager diversification offers little real protection.

Current expected returns and allocations are low, so why bother?

Allocations are low because forecast returns are low, not because there is anything irredeemably wrong with the asset class. Prices are simply too high compared to the fundamentals. But this will not always be the case.

There may well come a time when AREITs appear to be a once-in-a-generation bargain that produce wonderful long-term gains for investors.

Markets often go through long-term cycles of euphoria followed by panic, followed by premature bargain hunting, then disappointment, before loathing and finally utter boredom sets in.

In our view, REITs are in the loathing stage. Boredom is probably still a few years away, and they are certainly not bargains yet. But that time may well come. 

Some notable examples of unloved asset classes becoming standout investments include Australian government bonds which, after a decade of negative real returns, could be locked away in 1982 at 16.4 per cent per annum for 10 years.

Gold spent 20 years in a bear market between 1980 and 2000. Since then, it has been one of the best-performing asset classes.

Emerging markets had become popular in the early 1990s before producing nine years of awful underperformance between 1994 and 2003. Since then, they have strongly outperformed developed markets.

There is every chance that this pattern will be repeated with AREITs some time in the future.

Have the problems been sorted out?

Despite being tidied up over the last few years, AREITs are still not without their problems. The two major ones are the ongoing potential for excessive gearing, and the continuing presence of management that seems to be oblivious to the interests of unit holders.

But it seems to pale into insignificance when compared to the issue of gearing. In fact, without gearing, even poor management would be of only passing concern to investors.

Gearing needs to be brought down and kept down

Gearing results in negligible increases in returns on the net amount invested, and it actually reduces returns on a portfolio basis.

It increases correlation with equity markets, increases the impact of poor asset management, and dramatically increases risk of poor capital management. 

Because expected returns on real property are around 8 per cent to 9 per cent per annum, borrowing at 7 per cent per annum has very little impact on returns.

With 30 per cent gearing, returns on a property fund could be increased by about 0.3 per cent to 0.6 per cent per annum before management fees and transaction costs. An allowance for these would remove much of that incremental return.

In any event, even this gain is spurious. If an investor wanted a $100,000 exposure to property in a portfolio, they could invest $100,000 ungeared or $50,000 in a geared portfolio that effectively gave the investor $100,000 property exposure and $50,000 debt.

This would leave the investor with $50,000 to invest in cash to offset the debt in the A-REIT.

Assuming the investor receives 4.5 per cent per annum on the cash and pays away 7 per cent per annum on the debt, the net effect on the overall portfolio return is that the investor in the geared product gets exactly the same return as the ungeared investor, less $1,250 per annum, which is the interest rate difference between what is earned on the cash and that which is paid away by the fund on its debt.

While not increasing returns, gearing does dramatically increase risk.

It increases the correlation between returns on AREITs and the broader equity markets, as both respond to the same factor – rising borrowing costs.

Back in the distant past, when gearing was much lower, so too were correlations between AREITs and equities much lower, and diversification was enhanced.

Gearing also increases the risk of bone-headed investment decisions aimed primarily at increasing the remuneration of the managers.

Without debt, the key errors management can make are bad acquisitions and bad developments. Both are hard to do in an environment where they have to be financed by raising equity capital from shareholders, who naturally want to be convinced they are getting a good deal.

Contrast that with a deal financed by bankers, who are only concerned that they get their loan repaid, which will happen as long as the manager hasn’t bought a property that is about to lose more than 50 per cent of its value.

Even an acquisition that is 20 per cent overvalued is a good deal for a banker who only lends 50 per cent of its value.

Without excessive debt, the ability of management to destroy significant value is also limited because the size of deals is limited.

By way of illustration, a poor acquisition valued at 10 per cent of the capital base of the fund will only reduce fund net asset value by 2 per cent, if it proves to be 20 per cent overvalued.

Unpleasant, but not catastrophic.

But the most significant risk introduced by gearing is the risk of poor capital management, as was so vividly illustrated in the debacle witnessed in 2008 and 2009.

During this time, as shown in Figure 1, the average A-REIT fell in value by 68 per cent. Investors were left with just 32 cents in the dollar. Contrast this with the average fall of 10 per cent to 20 per cent in underlying property valuations.

Capital management is a huge risk factor.

Will gearing be brought permanently into line? Eventually, perhaps. Meanwhile, we watch and wait. Even with the issues associated with gearing and misalignment of management incentives, there will be a price at which these assets again become attractive.

Tim Farrelly is principal of specialist asset allocation research house, farrelly’s.