Building strong foundations

When it comes to the double digit returns that super funds and their members have enjoyed in recent years, few would hesitate to attribute such success to the strong performance of the Australian equities market. However, in an environment in which interest rates and rental rates are on the rise, property, both listed and direct, continues to be a staple allocation for many funds.

According to Mike Wyrsch, senior consultant at Frontier Investment Consulting, property returns have echoed the equities market to some extent.

“While domestic equities have undoubtedly underpinned superannuation returns, property has been very strong as well,” he said. “Real yields have compressed a lot over the last few years, asset prices are inflated and price-earnings ratios look all right as well. Property certainly isn’t cheap at the moment.”

For Mark Delaney, chief investment officer of newly formed industry fund Australian Super, all Australian assets, whether equities, listed or direct property, have performed very strongly in the last three years.

“Much of the strength of those returns has been underpinned by resources performance,” he said. “All markets have gone up, but looking at property specifically, we have seen increases in rents and an increase in overall demand. While property has certainly been less volatile than Australian equities, it certainly hasn’t lagged.”

Delaney said Australian Super’s current allocation to property stood at around 10 per cent, aligning it with the fund’s average weighting over the last seven years.

“Our allocation to property is a function of market conditions and property availability rather than any particular benchmark,” he said.

It seems a major feature of property allocations over the past few years has been that as predominately Australian assets, they too have felt the successes of domestic equities while enjoying the lower volatility inherent in the class. But in an environment in which inflation and interest rates seem set to keep rising, can that trend continue?

In answering, Wyrsch is quick to point out that as large-scale investors, super funds look at long-term yields rather than short-term cash flow.

“But regardless, property’s underlying fundamentals are strong,” he said. “And that stands them in good stead. If any concern exists related to property, it is that if bond prices rise, property returns are likely to be hurt.”

Sandy Grant, chief executive officer of building and construction industry fund CBus, sees little to be concerned about. For him, the reality of being long-term investors means the fund will simply ride out the less wonderful times in anticipation of better times ahead.

Delaney’s thoughts echo Wyrsch’s views on interest rates.

“Interest rates have indeed risen, but as yet, bond yields haven’t followed suit,” he said. “They haven’t risen a lot just yet. If they do, however, property returns will definitely go down.”

So if interest rates are of limited concern to the institutional investor, what barriers do exist in the property marketplace? One obvious answer is availability, with many industry experts observing that high quality property investments became increasingly difficult to obtain last year.

According to Wyrsch, the solution that many funds are increasingly embracing is global property.

“I think we are definitely seeing more funds looking to invest in property in offshore markets,” he said. “Tax-wise it is getting easier, but also, funds themselves are getting bigger and better able to deal with the currency, taxation and management issues involved.

“In the past, tax has been a big cause for hesitation on the part of super funds looking to take this route,” continued Wyrsch. “Traditionally, property has been a local undertaking, but investing offshore changes things. It is important to pick the right managers and the right structure, but the question lies in how a fund does this.

“I think the risks are definitely worth it, but you have to do your homework first,” added Wyrsch.

Interestingly, Delaney stated that Australian Super saw quality property assets as easier to obtain in the last two years when compared to the previous three years.

“We’ve seen many LPTs (listed property trusts) increasing their offshore portfolios and selling domestic property off their balance sheets,” he said. “If anything, property availability has increased.”

With close ties to its building and construction industry members, Grant said CBus had a unique perspective on property as an asset class as well as the alternatives not available to other funds.

“Firstly, we’re not widely exposed to listed property,” he said. “Our involvement is restricted to direct unlisted trusts in favour of the insulation and diversification from the equities market that those trusts offer. However, property availability certainly hasn’t been a concern.”

Grant said CBus currently had three-quarters of a billion dollars in construction underway and that the construction option placed the fund in a very strong position when it came to obtaining quality property assets.

“We can buy or build, so at the moment we’re building,” he said.

Yet, without the option of building investments rather than buying them, most funds have been forced to examine opportunities for property investment abroad, albeit to differing extents and always with great caution.

Delaney said Australian Super was actively looking at property investments globally.

“We are always looking for opportunities offshore,” he said. “And are looking to increase our allocation to international property as good opportunities arise. However, we are very conscious of a number of factors. Taxation is important, as are well structured vehicles.”

On the investment consultancy side of things, Wyrsch also advises caution.

“If looking to invest offshore, there are many opportunities to be had in both Europe and particularly in Asia, where rental returns compared to interest rates look very good,” he said. “At the moment, we’d suggest diversifying away from the US, which currently looks a bit expensive. But I think it’s toe in the water time for funds.”

Wyrsch said that, as the market currently stands, Frontier would not suggest maintaining any particular target allocations to property.

“That said, the projections we’ve done have all made it clear that property investment will increasingly head offshore,” he said. “You simply can’t get enough here.”

For Grant, global property investments are deserving of caution.

“At this time, CBus hasn’t made significant moves to invest in overseas property,” he said. “The fund currently has around $11 billion invested in property across all sectors. Of that, a mere $130 million is invested outside of Australia, so I think it’s fair to say that we’re cautious when it comes to global property.

“I suppose that in terms of property, if no alternatives exist locally other funds might choose to go offshore, but CBus chooses to take the options available to it. We are continuing to look at opportunities overseas, but at present, the risks are too high when alternatives exist,” finished Grant.

Obviously, investment in offshore property is not the only way funds are able to diversify their property portfolios. In the past, varying property sectors have attracted interest from a number of investors, however, when taking this route, Wyrsch said caution should remain the order of the day.

“If a fund is weighing up whether to diversify across property sectors, they have to see if it makes sense,” he said. “Investment in residential is difficult to make stack up, and agricultural property is certainly less than encouraging. It may be different moving forward, but certainly at the moment, the traditional sectors are the best bet.”

Grant said CBus aimed for the diversity within the traditional property sectors that Wyrsch recommended.

“We have investments in a number of different areas, including communications, retail, and industry,” he said. “And we aim to diversify our portfolio geographically as well. Our preference is to invest with players in specialist positions, like office refurbishment for example.”

In the same way the Australian domestic equities market has fuelled superannuation returns so well in recent years, it seems property continues to have a vital role in fund allocations. However, despite what most perceive as a decrease in the availability of quality property assets, investment offshore continues to be viewed hesitantly, with funds instead favouring the less volatile and more secure option of investment in their own backyards. And why wouldn’t they, with Wyrsch predicting property returns would again reach double digits this year.

“Returns for property look pretty good again this year,” he said. “We think they might be in the 10 to 20 per cent range, but they will certainly be double digit with the good rental increases that we have been seeing, but they certainly won’t stay there over the longer term.”