Property syndicates built on shaky foundations

No doubt some property syndicates are well managed and will produce sound returns for investors. However, certain features, which are quite widespread in syndicates, would be considered entirely unacceptable in any other form of managed investment. (I acknowledge up front that there are individual variations that this article cannot take into account.)

A fundamental problem faced by all managed property investments is the challenge of liquidity in a pooled investment structure which holds illiquid assets.

Unlisted property trusts floundered at the start of the 1990s. Sentiment turned against property and they suffered substantial net withdrawals. They found themselves with a queue of redemptions when the funds were tied up in buildings which required considerable time to sell in an extremely weak market.

Listed trusts solve the problem by trading units on a stock exchange but with the consequence of increased volatility. It is sometimes argued that these provide inadequate portfolio diversification as they tend to move in line with equities. There have been times when this was so, but certainly not in recent years. The returns from the All Ordinaries Accumulation Index and the Listed Property Trust Accumulation Index have diverged materially.

In fact, listed trusts have been an excellent diversifier while stock markets have been weak.

The structure of property syndicates varies, but generally, they address the liquidity problem with a fixed term with no redemption rights in the meantime. This does prevent withdrawals from causing the structure to collapse, as occurred with unlisted trusts. However, saying to investors who wish to withdraw that they can’t does not solve a liquidity problem — it is a liquidity problem.

Having to irrevocably commit capital to an investment for a period of, say, a decade, irrespective of changes in personal circumstances or investment markets, is inherently undesirable. Investors would surely require the prospect of a much higher return than from an alternative investment to reward this increased risk.

In any case, investing with a sale date determined years in advance, irrespective of whether it is an attractive time to do so, is an unusual concept.

However, there is often the possibility of extending or shortening the term by a vote of investors. The idea that one’s right to sell an asset or not is out of one’s own control, and is subject to a vote of strangers who don’t understand or care about one’s personal financial situation is, to me, abhorrent. Imagine the sense of loss of control if you vote for termination and the majority do not.

There is also substantial evidence that inflow into market sectors is greatest when they are at a peak and outflow is greatest at a low point. Thus, one could find that the majority votes to wind up the fund at the very worst time.

The lower perceived volatility of syndicates arises from the fact that the properties are only valued periodically, say annually. Valuation is a very inexact science as anyone who has ever received an estimate of their property value before putting it to market knows.

Valuers must base their appraisals on evidence, usually recent comparable sales. In the 1990 unlisted trust debacle, everyone knew that the market was collapsing but the latest transactions of landmark properties had been at the peak. Thus, the prices ultimately realised for prime properties were far from net tangible assets.

Similarly, syndicate investors do not have a precise idea of such basic information as what their investment is worth at any point in time.

Syndicates usually incur exceptional costs. The transaction costs of managed funds, including listed vehicles, are only those you incur to buy/sell the units. You do not have to pay for the entire costs of establishing, and later terminating the trust; nor those of buying and later liquidating the entire portfolio. The fund and the portfolio precede and endure beyond your tenure as an investor.

In a syndicate, the investors have to pay for the creation and termination of the fund and the acquisition and disposal of the properties. As real estate carries much higher buy/sell costs than any other asset, these must have a material impact on return. I have seen syndicates where these were likely to exceed 15 per cent of investors’ initial capital (due to gearing).

In addition, some syndicates carry much higher managed expanse ratios than are generally acceptable for listed trusts. There are also examples where initial fees are described in ways that can mislead the unwary. For example, I have seen entry fees described as being five per cent of the ‘value of the properties’. This was in a fund which geared 1:1 so it represented 10 per cent of investors’ capital.

However, fee structures vary widely so it would be unfair to generalise. Sharp practices with fees are not exclusive to any one investment type.

Many syndicates have very high gearing. By definition, gearing increases risk.

In principle, I believe it is better to have investors gear to the extent that they wish and buy ungeared assets, rather than invest in funds with internal gearing. This allows for separate decisions to be made about decreasing gearing or selling the asset. For example, if it was believed property was in a period of flat growth, it might be appropriate to invest in it, but not to gear into it.

While the portfolios of syndicates will vary widely, it is common for them to offer a very high-income yield. Double-digit income is not unknown. It is a tautology to say that a high yield property is one which commands a low price for the rent it produces.

The naïve might hope that if, say, a 10 per cent yield is added to growth in line with inflation, say three per cent, there is the prospect of a spectacular return. Indeed, this would be spectacular — but highly unlikely. No-one would buy a property yielding five per cent if there were properties yielding 10 per cent with equal security and growth prospects. A property selling cheaply (ie. a high yield) is doing so because of risks either to the future income stream or capital value.

Today, gearing increases cashflow as rental yields exceed the rate on borrowing. However, if it is acknowledged that high yield properties are trading at lower prices because they have the prospect of lower growth, this is an unusual asset for gearing.

The strangeness of the syndicate structure may simply be illustrated by the analogy with a hypothetical investment offered by the “You Can’t Be Serious Asset Management Company”. This will be an equity trust with some unusual features.

The fund will have a 10-year life and can’t be redeemed in the meantime, no matter how much your personal circumstances or market conditions change.

The fund must be wound-up in 10 years’ time, whether it is a good or bad time to do so.

However, the majority of investors can out-vote you on whether you can access your money at the end of the term or at other times.

It will have much higher costs than a typical managed fund, particularly in regard to buy/sell expenses.

It will involve a high degree of gearing, fixed years in advance of knowing market conditions.

You will not have a very precise idea of the investment’s value at any time over the next 10 years. Once a year, there will be an approximate estimate made. This may have a benefit in that you will experience nil volatility during each 12-month period.

If a fund manager approached financial planners with such a proposal the reaction is likely to be: “You can’t be serious!”

Not all syndicates are structured this way, but a significant proportion are. These funds differ from this analogy mainly in that they invest in property rather than shares.

Is the fact that you actually know what a listed trust is worth at any point in time, and therefore recognise its volatility, so undesirable as to make the syndicate structure more attractive?

YearPropertyShares

1999-5.0%16.1%

200019.7%4.4%

200112.8%9.2%

200211.8%-8.1%

Source: Morningstar