Property investment strategies in a post-GFC world
Coaxing clients back into property post-GFC may not be as hard as some imagine, so long as you get the balance right, writes Damian Fitzpatrick.
It has become increasingly difficult to navigate the investment landscape in today’s uncertain environment. Investments parked in the safety of bank term deposits are no longer enough for your clients looking to increase their appetite.
Yet the jump straight into equities is too risky given the prevailing market conditions. Property seems to be the logical asset class given its average yield of 7 per cent, but how do you convince clients that ‘property’ won’t suffer the same 70 per cent fall in value it did during the Global Financial Crisis?
Will property funds experience the same liquidity issues again?
Direct v. indirect property
Property investment is an easy concept for most investors as the underlying assets are in the tangible forms of a commercial office building or a shopping centre, generating investment returns through a combination of yield (net rental incomes) and capital growth (increases in property value).
What most investors may not realise is that property exposure can be in the form of direct or indirect investments.
This means assets can be directly held through a direct ownership on the title deeds or indirectly through syndicates or investment vehicles such as a listed property trust known as real estate investment trusts (REITs), which are listed on the securities exchanges.
Through direct property, investors have the comfort of knowing they have invested in a tangible asset. And unlike financial assets such as shares and bonds, it performs and reacts differently in varying economic conditions and has less risk profile compared to shares.
However, one of the biggest disadvantages of investing in property directly is the lack of liquidity given the substantial amounts of capital required to initially purchase the asset. Ongoing maintenance of the building is also costly and requires expertise in building management.
REITs, on the other hand, allow investors to purchase an interest in a diversified portfolio of real estate in the same way as you would purchase a share in a company or a unit in a managed fund.
Through REITs, investors can gain exposure to assets that would otherwise be too costly and not readily accessible – for example, global property opportunities.
However, as REITs are listed and traded like shares, their values are subject to external factors apart from pure rental collection and are highly correlated to share movements, limiting their diversification benefits.
Regardless of how property assets are held, property investing can offer some taxation benefits such as depreciation of buildings. Property investments also offer stable, contracted revenue streams in the form of rental payments.
Typically, rental agreements would have clauses of rental increases that are linked to inflation, delivering real income to investors.
Due to their differences, direct property and REITs offer different diversification benefits against shares and bonds and both should be part of a balanced portfolio.
Combining direct and listed property
We can see from Graph 1 that listed property is more closely correlated with the broader equity markets.
This is not surprising due to its listed nature, but it is important to understand that since the GFC, REITs have deleveraged significantly and have reduced non-rental income sources, returning to being more the traditional vehicle they once were.
Direct property investments, on the other hand, are not typically impacted by speculation and listed market volatility.
As a result, the investment value reflects the real value of the underlying assets, not market sentiment, allowing unlisted property to be significantly less correlated to other asset classes.
This lower volatility is at the expense of less liquidity, so a key consideration when constructing portfolios is to understand how your clients view this trade off.
Long-term income stability
A compelling feature of property investing is the stability of income over the long term. This is particularly attractive to investors near or in retirement.
Graph 2 shows that direct property has returned a total return of 10.1 per cent per annum over the past 26 years, of which 7.5 per cent has come from income returns; ie, income from underlying rents.
It is also clear from the chart that despite the increases and falls in capital values of the underlying property asset, the yields from direct properties’ rents have proven to be extremely consistent.
This means that in tougher economic times, retention of tenants is critical for preservation of income and preservation of distributions to unit holders.
This is where experienced management is important in identifying or managing quality properties in order to attract a diverse spread of lower credit risk national tenants as opposed to secondary properties with higher risk tenants.
Fitting property into client portfolios
Many advisers have told us that they have stopped or reduced allocations to property since the GFC, but the Reserve Bank of Australia’s data have shown otherwise.
We believe the real question is not if property is appropriate, but rather what type of allocation is suitable for clients’ objectives?
As you can see from Graph 3, property has historically represented between 10-21 per cent of a managed portfolio.
I believe that property should form between 8-15 per cent of a balanced portfolio, with the risk appetite of the investor determining where within this range it should be.
Those investors close to retirement should seek investments with a steady income distribution, which could be a number of property investments.
Conversely, those investing over the longer term may seek more risky investments than core property.
Exposure to direct and listed property
A balanced portfolio will also benefit from a hybrid mixture of direct and listed property. Graph 4 shows the hypothetical performance on $1 invested in a number of sectors and benchmarks.
The chart highlights the difference in performance between listed and direct/wholesale property during and after the GFC.
The Mercer/IPD Index represents the returns from direct properties held within Australian wholesale funds.
The A-REIT 200 Index represents the performance of Australian REITs while GREITs reflect the combined global index, specifically the FTSE EPRA/NAREIT Developed Rental index which incorporates REIT returns from Europe, Asia and North America.
By blending a strategic mix of listed and direct assets, the AMP Capital Core Property Fund is able to smooth returns through the cycle, lowering the volatility and improving risk-adjusted returns.
As you can see from Chart 5, the Mercer/IPD index would have provided investors with the highest return for the least amount of risk. However investors are not able to invest in this index.
The AMP Capital Core Property Fund allows investors to gain access to investments in REITs and direct property and provides a better risk-adjusted return.
Lessons to remember
The GFC has taught us, if nothing else, the importance of sticking to the fundamentals, keeping things simple and remaining focused.
This is definitely true in the case of properties, as the losses incurred by many REITs during the GFC have been largely due to over-gearing and divestments into areas that are not core to property investing.
Going forward, responsible property investing should be to look for underlying properties with sustainable competitive advantages in location, quality and zoning restrictions.
Investors should also look for good properties at fair prices over bad properties at cheap prices. Property investments shouldn’t be highly geared or complex. And short-term liquidity matters – don’t buy during panics and don’t be forced to sell.
Damian Fitzpatrick is the portfolio manager of the AMP Capital Core Property Fund.
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