The changing face of property funds

Mark Dutton

In recent years, a frequently canvassed topic in financial services circles has been the changing nature of the listed property trust (LPT) sector.

It makes good sense to include property related securities in a well-diversified portfolio strategy, but increasingly, LPTs have been behaving more like high-flying shares than a conservative asset class.

LPTs — a paradigm shift

Returns generated from the Australian LPT sector have outpaced the broad share market index over most periods extending back for 10 years or more.

In 2006, the LPT market posted yet another spectacular gain. Boosted by a 14 per cent return in the final quarter, the return for the full year reached 34 per cent, well ahead of a very strong share market return of 25 per cent.

The past few months may have offered us a preview of what may happen in this sector should conditions become less favourable.

Despite another strong start to the year, the LPT sector finished the March quarter with a negative return of 2.3 per cent, underperforming the broad share market by more than 9 per cent.

The LPT market reacted violently to news that also triggered general equity market volatility, including a sharp sell-off in Chinese stocks on the Shanghai Stock Exchange, news of an increased risk of a slowdown in the US, and concerns about the US ‘sub-prime’ mortgage lending market.

The issues that triggered recent volatility in the listed property market are not in the textbook of things that Australian LPT investors would normally need to think much about. But they are now.

The changing nature of the market means many Australian LPTs have offshore exposures.

There are some benefits to this trend, but it does mean that developments overseas can now have a direct impact on an Australian LPT portfolio.

From a new high in late February 2007, the Australian LPT Index fell by 8.8 per cent in less than two weeks. This is not the kind of volatility that property investors might traditionally have expected.

Most of the stocks with big negative returns were among last year’s star performers, while many of the laggards from last year got through this period of volatility with positive returns.

Drilling down into the LPT sector reveals several other key developments worth noting, nine of the top 10 performers in 2006 were ‘stapled’ securities. These securities effectively staple together interests in property management, development or portfolio management activities along with real estate exposures, and now make up around 75 per cent of the market capitalisation of the sector.

These securities have been able to boost earnings growth well beyond prevailing rental growth rates with the addition of corporate earnings and leverage, much like ordinary shares.

In addition, earnings growth over recent years has been boosted by asset sales.

The very strong returns achieved by LPTs over recent years have left many stocks in the sector, particularly those structured as stapled securities, looking far from cheap by conventional valuation metrics. However, while big names like Centro and Macquarie Goodman have been trading on a price to net tangible assets ratio of around 250 per cent, many smaller stocks in the market index appear to be trading on a more modest premium to net tangible assets of around 20 per cent to 40 per cent.

So looking across the whole LPT sector, it is clear that some securities are likely to behave more ‘defensively’ than others.

Consistency is the key

While the returns and volatility experienced over recent quarters in LPTs are more share market-like, over the same periods we saw returns from the unlisted property sector accruing in a more ‘property like’ manner. Returns from unlisted property (Mercer’s Australian Unlisted Property Trust Index) ranged from 3.3 per cent to 4.8 per cent per quarter over the past year, and a further 3.7 per cent return was recorded for the March 2007 quarter.

Clearly, the unlisted nature of this market means that there is no real measure for the true volatility of valuations. But it is also clear that strong market fundamentals in Australian real estate markets have continued to support good returns and solid income growth.

Funds investing in direct property assets most commonly seek to build a diversified exposure to office, industrial and retail property, and gain a good geographical spread. Conservative funds will have little or no gearing and earn returns solely from the rental income and valuation changes of the underlying properties.

Retail opportunities scarce

Direct retail property has continued to perform very well, helped by positive trends in retail sales.

Retail spending data for January and February certainly surprised on the upside, with February spending at its highest level in nine months. After moderating in 2006, consumers appear to have shrugged off three rate rises and higher petrol prices, and the outlook for retail spending remains positive given the strength of the job market, wages growth and falling inflation.

This retail turnover is supportive for income in retail property, but the growth from the sector has pulled back after strong gains in 2003 and 2004 and there appears to be less potential for strong capital growth in this area in the short term. This is already evidenced by compressed yields in the retail property sector, although given the amount of new supply expected in 2007, we may not see yields fall much further.

Opportunities still remain, but they are harder to find and success may entail looking beyond the heavily contested major metropolitan markets.

Office space limited

The office sector is currently experiencing very strong demand. This demand, combined with limited new supply has seen vacancy rates plummet.

The market is particularly tight in Perth and Brisbane, where the resources boom has added to demand, and brought vacancy rates down to below 2 per cent.

Strong demand is having the inevitable effect on rental rates, with strong double digit growth set to continue. However, investors still face a challenge, as demand for property assets remain high, forcing yields lower in the hotly contested markets.

Strong Australian dollar lifts industrial sector

The industrial sector is generally regarded to be in an upswing phase, although it may peak prior to the office sector. The industrial sector is being strongly supported by the volume of imports into Australia and, to some extent, by the strength of the Australian dollar.

However, as DBRREEF notes in its latest quarterly report, developers are planning to build more than three million square metres of new industrial stock during 2007.

This record amount of new supply may result in some near term weakness in rental growth rates, although risks are partially mitigated by pre-commitments totalling around 57 per cent of the new stock under construction.

Are hybrids the right mix?

LPTs can no longer be regarded as a proxy for direct property. It is still a valid asset class, but should not simply be considered as a direct property portfolio with liquidity. Because the nature of the asset class has changed, its role in a diversified portfolio must also have changed. Much portfolio modelling still in use assumes LPT returns and volatility outcomes to be somewhere between bonds and shares, and for correlations of returns to be relatively low.

The new era of Australian LPTs introduces more ‘equity-like’ risk and return potential, and also faces the likelihood that returns may be more highly correlated with mainstream equity market returns.

Direct property portfolios continue to offer ‘property-like’ exposures, and, along with these, inherent limitations on liquidity and timely valuations.

Well-designed ‘hybrid’ property funds provide investors with a managed pool of assets typically comprising LPTs, direct property investments, and a small amount of cash and related securities. These funds do provide strong diversification benefits relative to shares and fixed interest, exposure to property markets, plus liquidity and daily unit pricing.

Little wonder that the sector is now attracting strong support from advisers and investors.

The research group Managed Investments Assessments recently reported that the hybrid property sector grew by 400 per cent over the past two years.

Funds now on offer include those managed by established groups such as AMP, AXA, Challenger and Perpetual, and a number of new funds have recently been launched with different degrees of risk and exposure.

As demand for hybrid property increases and money from superannuation investment pours into this sector, it is becoming more intensely researched and competition is mounting. As a result, there has been a swing away from smaller property vehicles, such as syndicates of $50-$250 million.

The consolidation of smaller funds into larger funds has lifted the calibre of many of the investments, meaning funds are more diversified across sectors in the number of properties they hold.

All segments of the property market have experienced strong demand resulting in increased valuations, and reduced yields. Two key strategies for such times are research and diversification. Intensive specialist research into each individual asset needs to sit alongside overall market analysis to help identify the best opportunities.

Diversification across both listed and unlisted assets, and a strong spread of assets across market sectors and geographical markets, is a sound approach to accessing the benefits of property exposures in a diversified portfolio.

Mark Dutton is the chief investment officer of AXA Asia Pacific.