Property as a defensive asset class

The property investment sector has changed significantly in the past few years. However, the reasons for investing in property — usually as a defensive, income producing measure within a portfolio — have not.

Therefore, in order to receive the same style of defensive investment that investors expect, they need to change the way they look at this sector and the way they select their investment vehicles.

The allocation of property within an investment portfolio usually aims to secure the bond type attributes of this asset class. It is a defensive investment to the extent that asset values are less volatile when supported by quality covenants and stable income streams.

However, is it still appropriate to call the ASX-listed property trust (LPT) sector defensive?

When one analyses the ASX LPT sector, the top five LPTs represent more than 60 per cent of the index. These are all stapled securities and, therefore, due to the corporation component, behave more like general equities than LPTs.

These top five ASX LPTs, which include Westfield, Centro, Goodman and Stockland, are no longer simple rental models, but sophisticated global property companies.

In short, the LPT market is two-tiered, with the top five LPTs representing growth, and the balance of the market being largely traditional LPT investments with unit prices reflective of their underlying tangible assets and the rental yields of those properties.

This second tier of the LPT market has lower volatility. This is due their restraint on price movements.

For example, a $1 unit price supported by net tangible assets (NTA) and an income yield of 10 per cent can only move a small percentage upwards and downwards.

This is because underlying yield needs to reflect the market yield of the property, and the growth is typically consumer price index, as rents are generally tied to this measure. Any sustainable premium or discount would need to be supported by fundamentals outside these parameters.

The average second tier NTA premium is some 15 per cent against the LPT sector of 80 per cent.

The top five pricing fundamentals are beyond the traditional defensive qualities of the LPT sector.

The premium is said to be reflective of the stronger growth prospects of the stapled securities; however, their average five-year internal rate of return (IRR) is 11 per cent compared with a portfolio underweight the top five of some 14 per cent. The top five LPTs are aggressively priced.

So why is all of this important? Investors either need to have a strategy that reflects the two-tiered nature of the ASX LPT sector, or seek out a manager aligned to this strategy.

Such a strategy will allow total returns to be correlated with the index although biased towards income.

In addition, segmenting a portfolio between the two market tiers is highly advantageous because an investor is better able to allocate funds through the property cycle to those parts of the portfolio providing the best defensive risk-return dynamic.

For example, at the start of the property cycle an investor is likely to be overweight to their index portfolio, as these growth assets are anticipated to be priced at tangible value with little premium for growth.

Currently, an investor would most likely be underweight the index and overweight the second tier, due to the LPT sector’s strong pricing premiums. They would also likely be overweight in unlisted property because of the maturity of the cycle.

The blend of property returns provided by these portfolios also subsequently lowers portfolio volatility.

Interdependent portfolios can invest across the spectrum of listed and unlisted securitised property, with portfolio allocation based on risk return rather than trading.

Such a strategy is risk averse and potentially able to create better long-term investor wealth.

The validity/evidence of this strategy is demonstrated in the composition of an investor’s return. As at June 30, having a portfolio that was 80 per cent LPTs, with that segmented between 40 per cent index LPTs and non index would have provided indicative returns of 27 per cent, including an annualised yield of 8.8 per cent for the 2007 financial year.

The broader index provided a return of 26 per cent, with a yield of 6 per cent over this period. Importantly, the portfolio volatility would be less than the index.

The property investment universe is broad.

This structure and diversity is not apparent for many investors. It encapsulates bricks and mortar (home, commercial, retail and industrial) and property securities. Property securities include ASX-listed property trusts and stapled securities and unlisted property trusts.

Each type of property will behave differently as markets change and the investment structure in which it is held.

While complicated, it is important to understand this, as investors can enjoy all the traditional benefits of property without the large capital demands that it once had and with liquidity it never had.

A shortcut to ensure a truly diversified and defensive property portfolio is to seek industry professionals, understand their investment view and their underlying strategy for that view.

Finally, their performance should provide evidence of the manager’s investment view and strategy.

Paul Nielsen is fund manager at Real Estate Capital Partners.