Broken homes?

Direct property has always had a place in the hearts of Australian investors. And little more than a year ago, with lower interest rates, a strong global equities market and high credit confidence, that fondness for bricks and mortar was justified. But Jonathan Stagg, consultant at Frontier Investment Consulting, believes the perfect picture of property may have changed.

“The pressure we’ve seen on listed markets lately has had a natural affect on allocations,” Stagg said. “And that has put most portfolios overweight to direct property due to the far less frequent valuations to be had there.

“But property has itself been influenced by the capital market and there’s certainly risk on the space side of the equation,” he continued. “So with credit and margins moving against leveraged buyers, there’s a big expectation out there that valuations will continue to soften.”

Paul Little, financial adviser for Landmark Financial Management, said he too saw investors being pretty cautious about property.

“Markets are hard to predict but we’re now entering a period of high interest rates and high inflation,” he said. “So I’d say that the outlook on direct property is pretty subdued.

“At this point, we haven’t seen any shifts in direct property allocations from our clients but then, tweaking allocations in this kind of space isn’t exactly easy,” Little continued. “However, for the first time in around five years, I think clients are feeling that property prices are more likely to fall than go up.”

Alternatively, when it came to fitting direct property into the current investment equation, Neil Smoli, managing director of Aviate Group, said that much depended on the property sector you were talking about.

“There’s currently very little out there in terms of stock availability,” he said. “We have interest rates on the rise and next to nothing in vacancy rates, with no alleviation in sight.

“So while it is true that investors cannot expect the same sort of growth from their property investments as they were able to previously,” continued Smoli, “we feel it is better to get the discount today, rather than speculate tomorrow.”

And it seems that despite returns on direct property being less than stellar since 2007 ticked over into 2008, consultants and advisers are recommending that now is not the time for change.

Angela Jenkins, financial adviser for Tasmania-based advisory firm Davey & Scurrah, said that the focus had to be on where direct property fitted into a client’s portfolio.

“Obviously, direct property isn’t a liquid asset,” she said. “So when you’re talking about post-retirement, as we often are, then you’re after that liquidity.

“But for those clients with existing property investments, now is the time for retention,” Jenkins continued. “If you can sit tight, then yields are certainly sufficient to make selling unnecessary.”

Of course, the more shaky ground that direct property has found itself upon is unfamiliar territory. Traditionally, it has been first port-of-call for those investors looking to minimise the volatility of their returns without going down the path of fixed interest. But is that role being fulfilled?

From the financial planning perspective, Little said he could definitely see his clients and investors in general being more cautious about the property market as a whole.

“But I don’t think that uncertainty and caution is so much about volatility,” he said. “Rather, I’d say it’s a lot more about the sub-prime crisis and some of the high profile collapses that everyone has seen in this sector.

“Product structuring and gearing come into play as well, but I haven’t seen people choosing direct property over listed for volatility reasons,” Little added. “After all, the outlook for direct property isn’t particularly rosy either.”

Stagg said that while he expected direct property valuations to soften in the coming months, he certainly didn’t see volatility being on the cards.

“The mechanism’s slower than that and it takes a while to work through the system,” he said. “We’re not seeing volatility at the moment, but rather a tightening of liquidity.

“In the case of direct property funds, we’ve got a standoff between buyers and sellers happening, but there is still a definite place for direct property in fund portfolios.”

Ken Atchison, managing director of property specialists Atchsion Consultants, said he also felt direct property had a lot to offer portfolios in terms of stability, but added that the proviso was the level of gearing involved.

“Over the last 10 years to 2006, massive gearing was hugely beneficial in the direct property sector but this is no longer the case,” he said. “People have become carried away with the value-add from gearing and have forgotten that you can’t ignore the downside.

“Lowly geared direct property continues to deliver the returns you would expect and its attributes are those investors want in their portfolios, particularly now when the listed market is so uncertain.”

But the possibility of returns volatility is not the only problem affecting direct property as an allocation. Local property availability, particularly at the institutional level but also in the retail space, is a challenge yet to be confronted, according to Little.

“There have been big impacts from the supply side of the property market already,” he said. “Brisbane, for example, where Landmark is based, has a growing population and a pronounced shortage on the supply side.

“Naturally, that shortage pushes up prices,” Little added. “But government policy has a role to play and what they do has the potential to alleviate the affordability issue.”

For the Aviate Group, where dealings are mostly in the space of pre-construction and off-the-plan property, Smoli said that while there were still sites available, volumes were definitely off.

“We’re very discerning when it comes to our selection of developments for investors and we analyse very carefully,” he said. “In the course of a month, we might look at 20 to 30 developments, of which one to five will meet our criteria, so there’s definitely less stock available.”

Smoli added that Aviate Group’s reputation meant that vendors and developers would often seek them out with upcoming developments that fit their criteria, but there was no way to counter the shortfall, particularly with respect to population growth.

According to Atchison, domestic property availability in Australia is about supply and demand.

“Currently, much of the shortfall in domestic property stock can be put down to its purchase by highly geared investors,” he said. “And though I don’t think that shortfall is as bad as many long-term investors have been proposing, there is certainly a limit to the local market and good reason for global property investment gathering pace.”

But while global investment may be gathering pace, and though it represents a good alternative to a property market where opportunities are often hard to come by, not everyone sees it as a necessary move.

Though he acknowledges a shortfall in quality local developments, Smoli said there were enough opportunities to be had within Australia for those willing to look.

“The biggest issue when looking overseas, particularly in Asia, is transparency,” he said.

“In Australia, we may have a lot to do when it comes to dotting I’s and crossing T’s, but it means that we have one of the best systems in the world in terms of transparency and disclosure.

“So while there is still growth to be had here, we’ll stick to what we know, what we’re good at.”

And while Atchison may view offshore investment in property more favourably, he admits that the transparency issues referred to by Smoli remain a hurdle.

“The knowledge barrier is significant when investing in offshore property and the transparency issue is a very real one,” he said. “In Japan for example, where real estate market growth is attractive, transactions have traditionally taken place in a private market that does not necessarily encourage freely available information.

“Legal structures can have an impact as well,” said Atchison. “So while people are becoming more comfortable with investment in global property, I hope they are becoming more cautious as well.”

For his part, Little said he had seen a growing tendency towards global property investments but added that he saw that being driven by asset consultants rather than any sudden client interest.

“Clients have been receptive to adviser recommendations on global property, but it’s not something that’s been embraced,” he said. “More than that though, I think all global investments have been held back by the strong value of our dollar.

“So when it comes to global property and its attraction for investors, currency has had a big cautionary impact.”

Alternatively, Stagg said that while he did not see the disclosure of information as a problem, there were definitely other issues to consider.

“There are a lot of complicating factors in investing overseas, from tax leakage to currency hedging,” he said. “But regardless of location, information is the single most important thing to consider and it is simply harder to obtain with global property.

“Property, even global property, remains a local game.”

Yet whether investors are struggling for quality property assets locally or are instead looking to diversify in the midst of equities volatility, taking the leap overseas is certainly not the only option available.

According to Paul Noonan, managing director of APN Funds Management, looking to non-traditional property sectors could provide a further point of diversification for investors, provided good strategies were in place.

“With employment levels where they are at the moment, there is obviously stability to be had in the major sectors of office, retail and industrial,” he said. “However, value isn’t restricted to those sectors.

“We’ve been very active in identifying and developing evolving property sectors such as retirement villages, petrol stations and self-storage and have proven them to be worthwhile,” Noonan continued. “But sector aside, people need to remember that property investment is about a medium to long-term horizon.”

But if Little’s take on investment into non-traditional property sectors is any indication, then Noonan and APN Funds Management may have more ground to cover before the value of such wide sector diversification is truly realised.

“Given the kind of economic environment we’re in at the moment, and given what returns have been for the year to date, there’s a general sense that our clients are flying to quality and what they know,” he said. “Whether for the better or worse, the more sophisticated and more adventurous products out there are currently more of a turn off than a turn on.”

According to Noonan, it comes back to the confidence an investor has in their investment manager and the experience they have in specific property sectors.

“There are definitely risk areas where investment is possible,” he said. “Tourism and agriculture, for instance, are areas that we would not look at simply because of the number of factors affecting the success of those sectors that are out of our control.

“We can, of course, do nothing about floods and earthquakes, just as we can do nothing about drought.

“So we must try to limit those factors and de-risk as many parts of the investment as possible,” Noonan continued.

“If we do that, then it’s just about identifying quality property and putting in place a sound strategy. The good returns will follow.”

Of course, the burning question for every property investor is not so much one of strategy as it is one of time. How long will they have to wait until good returns again come to the fore and Australian property recaptures its previous strength?

Atchison said that he was looking to the listed market to provide the lead.

“We’re probably through the worst of it now,” he said. “But I don’t think the market can go ahead until the credit squeeze is eased.”

For Smoli, returns on direct property would be heavily dictated by inflation levels and interest rates for the remainder of 2008.

“If you look at what economists have been saying then interest rates are the main driver,” he said. “And as things stand now, they’re probably at or very close to their peak, so watch for when they come off.

“At that point, I’d expect property to pick up a lot of momentum once more.”