Solving the income dilemma
In an ultra-low rate world, it is becoming increasingly challenging for advisers to find ways to meet their clients’ income needs and deliver an appropriate risk-adjusted income return. One asset class worth considering with this in mind is unlisted property funds.
With the Reserve Bank of Australia’s cash rate near zero, and with some fixed income investments returning less than inflation, the temptation is to increase allocations to equities in an attempt to restore shrinking income levels.
However, the market volatility associated with the COVID-19 pandemic in March 2020 was a harsh reminder of the impact that being overweight to equities can have on retirement portfolios’ total returns.
As share prices fluctuated dramatically, particularly during the first half of 2020, many investors saw their income severely disrupted as companies were forced to cut or suspend dividends. Others had their shareholdings substantially diluted as companies were forced to raise new equity to repair their balance sheets.
Neither of these outcomes are a good result for investors nearing or in retirement, particularly when they may not have time to recoup any lost capital. This is a major concern for all advisers and unlisted property funds provide one approach that can alleviate this concern and deliver both capital stability and attractive levels of income.
ATTRACTIVE RETURNS
Most Australians hold their property exposure solely through the residential market. This is due in part to familiarity, as most investors are also homeowners, and because residential property provides investors with the ability to own and control the asset themselves.
Due, in part, to the many costs involved – including maintenance, land tax, management and agent fees and insurance – residential property investments often provide a low-income yield. Higher yields are often found by investing in commercial properties, but this sector can be harder to access for the average investor.
While negative gearing and the chase for capital growth is an acceptable or common strategy for investment into residential property, it is not a strategy that helps investors who are specifically looking for income. Nor is it a strategy commonly pursued by commercial property investors, where property valuations are based on the rental income they can achieve.
Higher yields can often be found by investing in commercial properties, but this sector can be harder to access for the average investor due to the much higher entry price point.
Property funds provide an alternative way to invest in commercial property for a comparatively smaller minimum capital requirement. These funds are professionally-managed which, if chosen wisely, can produce stable monthly income and capital growth over the term of the investment, without all the hassle of a residential property.
VOLATILITY, RISK AND CORRELATION
As unlisted property funds are generally priced based on the underlying value of their assets, which usually happens once every 12 months, their price volatility is a lot lower than listed asset classes, such as equities or real estate investment trusts (REITs).
This means that unlisted property has a low correlation to equity markets and other listed assets and can help provide valuable diversification benefits in a broader investment portfolio, particularly when public markets are falling, as was the case during COVID-19.
Investment risk can be further reduced by diversifying across funds that hold assets in different sectors such as industrial and office, or a variety of locations such as multiple states and regions, or CBD and CBD fringe locations.
Investing in unlisted property funds can also potentially provide additional stability and consistency to an investor’s income stream. A fund that invests in high-quality assets leased to blue-chip State or Federal Government tenants on a long-term basis (or WALE – weighted average lease expiry) will generally continue to pay consistent income, despite any negative impact on valuations that may occur over the short term.
As an example, the orange bars in Chart 1 demonstrates the consistency of the income stream paid from the Cromwell Direct Property fund since inception, with the blue bars displaying changes in capital growth over the same period.
At December 2020, the fund had a WALE of 6.5 years and held approximately 48% exposure to government or government owned assets. In total at December 2020, approximately 66% of the fund’s income was derived from a combination of government or government-owned assets and listed companies.
TAX-ADVANTAGED INCOME
Property funds can also have tax advantages that help to boost net income.
In a nutshell, a managed property fund’s distribution often includes a component of ‘tax-deferred income’, which has the potential to increase the after-tax return for an investor. This component is the result of differences between the cash earnings of the fund (the rental income less expenses) and taxable income.
The tax-deferred component of a distribution from an unlisted property fund is the result of differences between the cash earnings of the fund and taxable income (or the rental income less expenses of owning and managing the asset). The fund’s taxable income may be less than actual cash earnings due to deductions on depreciable elements of the underlying physical asset (such as depreciation on the base building and fitout), as well as the costs of raising equity and establishing a debt facility.
From the investor’s perspective, instead of being taxable in the financial year the income is received, the tax-deferred component amounts are deducted from the cost base of the investment. The reduction of the investment’s cost base as opposed to taxable income in the year received effectively defers the tax due until a capital gain event is realised, like the eventual sale of the units in the fund.
Managing the timing of the investor’s exit from an unlisted property fund can add to the taxation benefits of this type of investment. As with most investments, if the units in the property fund are held for 12 months or more, the usual capital gains discount may apply.
Redeeming the units when the investor has retired or stepped back from full-time work may result in capital gains tax payable at a reduced or marginal tax rate, therefore a reduced tax liability. In addition, the tax liability on redeeming an investment in an unlisted property fund can potentially be reduced to zero if held within a self-managed superannuation fund (SMSF). Deferring the redemption of an investment that pays tax-deferred distributions until the member is in pension phase will effectively reduce the capital gains liability to nil.
ACCESS TO UNLISTED PROPERTY AND SELECTING A FUND
Most unlisted funds are available through adviser platforms or directly via the managers website, rather than the ASX.
When it comes to selecting an unlisted property fund, a factor to consider is the manager’s track record and past performance. Although as is the case for all investments, past performance is not a reliable indicator of future performance.
Also consider asset specifics. Is the asset well located? Who are the tenants, what is the physical condition of the property and what are the lease terms?
Ideally, you want to see blue-chip or government tenants with long-term leases. Look at vacancy levels, the level of capital expenditure required and the fund’s green credentials. Other factors to look at are forecast distribution yields, liquidity, gearing and the level of fees.
Remember that all property investments should be considered over a medium to long-term timeframe of five years or more. As part of a balanced portfolio, unlisted property funds can deliver attractive risk-adjusted returns with lower volatility than equities.
Hamish Wehl is head of retail funds management at Cromwell Property Group.
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