No shelter from the storm for retail investors

In late March this year, the personal finance sec­tion of one of the major newspapers ran an article entitled “Unlisted property trusts — shelter from the storm”.

Taking the view it was one of the more dangerous pieces around, I took the unusual step of writing to the editor at the time. Below is an excerpt from that e-mail.

“… unlisted property is no ‘shelter from the storm’. It is more likely the next domino to fall and investors blindly moving into unlisted trusts (especially if switch­ing from now heavily dis­counted listed property trusts (LPTs)) are almost certainly making a mistake. Not only are they getting into something with almost certain capital loss as cap rates adjust (with a lag) to what’s going on in the real world, but they now sit in illiquid vehicles that in the current nervous climate, are at risk of increased redemp­tions, funds closures and/or forced sales. Wasn’t the sus­pension of redemption and losses (with more likely to come) on the Centro Direct (not listed) Property Funds warning enough? (and curi­ously not mentioned in the article)…”

With the recent suspen­sion of redemptions and applications for a number of direct and hybrid prop­erty funds from AXA, Chal­lenger, Blackrock, Mac­quarie and with more likely to come, it is becoming increasingly clear that unlisted property trusts offer little shelter from the cur­rent hostile environment, although the full extent of losses and inconvenience for investors and their advisers across various products is still to be seen.

There is no doubt the current investment environ­ment is enormously chal­lenging and is impacting in ways that no-one could have predicted.

However, this unpre­dictability doesn’t apply to unlisted property funds. After all, this has already happened here before. His­tory never repeats but it rhymes, and the parallels with the unlisted property trust crisis of the early 1990s should be familiar to most of the senior participants in this industry.

Investor/product mismatch

It all comes down to the simple mismatch involved in offering retail investors full liquid access to assets that are not inherently liq­uid themselves, and espe­cially so in tough times (I’m excluding closed end prop­erty syndicates here).

These funds have always had the ability to suspend redemptions, which is dis­closed in their Product Dis­closure Statements but this aspect is hardly likely to be highlighted in the sales process to investors. And weren’t the hybrid funds created specifically to avoid this problem?

The unlisted property trust crisis of the early 1990s saw most unlisted funds close to redemptions (many ultimately listing) and the underlying property per­form poorly, leaving investors poorer, inconve­nienced, illiquid and less trusting. It damaged the rep­utations of many in the industry. Time has eventu­ally healed many of these issues (including reputa­tions), but there are some valid questions to be asked as to why we have to go through that angst again.

Long-term dilemma

I am not suggesting the current situation, caused by this mismatch, will pan out in exactly the same way, but this is something that is unlikely to blow over quick­ly. The real issues for the direct property market and these funds will take years to work through, not months. The extension of the problems to hybrid funds (which didn’t really exist in the early 1990s) shows the breadth of the impact.

I am also not suggesting that fund managers are doing the wrong thing in closing the funds to redemp­tions at this point. They have little choice. But it reminds me of the dilemma of someone lost in the desert asking for directions to civil­isation; ‘I wouldn’t start from here’ comes the not so helpful advice.

The same dilemma faces the unlisted property funds industry. Resurrecting cred­ibility and investor confi­dence from the current start­ing point will be a formidable challenge.

Institutional investors have always come from a different perspective when it comes to direct property and other illiquid assets such as private equity.

The starting point is that such funds are assumed to be illiquid, although in good times there is usually a ready secondary market in good property funds (and in the underlying assets themselves).

The problem is that if such funds were positioned to retail investors in this way, as the illiquid funds that they are, they would generally not buy them. They would also not be offered on platforms and by most dealer groups that require liquidity and fre­quent pricing.

Bad property markets happen and retail investors react to liquidity fears by pulling their money. Who couldn’t predict that at some stage of the cycle unlisted property trusts would struggle to meet redemptions?

I suspect we have reached the point where these types of direct property vehicles will soon cease to be offered to the retail investment industry. Direct property funds will become an insti­tutional investment vehicle.

The jury is probably out on whether hybrid funds remain viable on a long-term basis.

Property syndicates and other closed-end vehicles may continue to be offered, although these too have many current issues, with many reaching the end of their term through what looks like a difficult market over the next one to two years, and with the addi­tional issues of facing high­er costs of rolling over/accessing debt. Indeed many direct prop­erty syndicates would face interest rates higher than the cash running yield of their property assets, and investors may well question the rationale of gearing that actually reduces the distri­butions per unit, particular­ly when the outlook for cap­ital returns are weak.

Only one of the funds that have recently suspended redemptions has suggested it will be listing on the ASX. I suspect it will not be alone. These funds will almost cer­tainly list at a substantial dis­count to their current NTAs (net tangible asset backing). Perhaps this is the appropri­ate path to take but it hard­ly represents shelter from the storm.

To address these issues, many managers involved seem to be hoping that things will get better and/or are try­ing to sell some properties to improve their position.

However, with a range of entities looking to sell prop­erty in the current market including financial compa­nies, listed property trusts and maturing syndicates, the supply is rising rapidly and the chances of receiving any­thing like the recent valua­tions is quickly fading.

Recent proponents of direct property funds have highlighted the differences between listed and direct property.

Real property

It is true that some listed property trusts went too far down the financial engi­neering and property devel­opments/funds manage­ment routes to be seen as providing good direct prop­erty exposure.

However, this never applied to the whole sector and is now in the process of reversing and, in any case, we are now in a situation where these peripheral activities are not being val­ued by the market or if they are, to a very small extent.

In my view, the debate about whether listed prop­erty is really property is not the point.

Will well run, lowly geared listed property trusts purchased at reasonable prices give you a decent return from the underlying property market over the long term? Of course they will and especially if pur­chased at significant discounts to even marked down net tangible assets (NTAs), which is where they got to recently with the index down over 50 per cent to mid July (and more if you take out the better performing Westfield that makes up around 40 per cent of the index).

Will listed property trusts perform terribly at some point (and even be poor long-term investments)? If you purchase them at 30 per cent premiums to NTA, then almost certainly yes.

The listed sector is likely to become less about devel­opments, less about funds management, and, with less gearing, more about the real property.

And if you can buy these trusts/funds at (possibly substantial) discounts to realistic NTAs then should one really care whether it behaves like direct proper­ty in the short term? You can be confident that it will outperform direct prop­erty in the medium-longer term and that is what really matters.

It is worth noting that in 1991, the year the unlisted property trust industry imploded and the direct property market suffered badly, listed property trusts returned over 20 per cent.

It is true that over the long term, all things equal, a sophisticated investor would prefer to hold a port­folio that contains both list­ed and unlisted property for diversification purposes (even if the benefits of the latter are somewhat exag­gerated).

However, investors should be willing to hold neither if they are not being properly rewarded for the attached risks. Twelve months ago, listed property trusts were not offering such a reward (but after falling 40-50 per cent almost certainly do).

On the other hand, six to nine months ago, as listed trusts began falling dramat­ically, it was direct property that became less and less attractive, particularly those funds available to retail investors that were subject to the risks of redemption runs and fund closures.

Lower gearing

The bigger picture is we are in a global de-leverag­ing cycle that probably has further to go. The multi-decade growth in leverage in the system has been halt­ed, but a broad reduction in gearing levels across the economy is likely.

Household debt, gearing in financial companies, structured finance arrange­ments and gearing into equi­ties, and so on, will all be subject to major reductions in debt levels.

In the long run, this will be good for the economy and markets, but it will be a very painful process on the way through, as it weighs on most asset prices.

It is, however, already cre­ating some outstanding investment opportunities (in areas including LPTs). The key is ensuring that investors are liquid and patient enough to participate in these.

It will also require courage to take advantage of these opportunities when the surrounding news is terrible. However, doing so will be near impossible for those too heavily invested in the ‘shelter’ of unlisted prop­erty funds.

Dominic McCormick is the chief investment officer at Select Asset Management.