Finding the right property mix

I recently presented to a number of dealer groups across the country discussing the property investment strategy of Real Estate Capital Partners (RECP) and plans for our flagship fund, Real Estate Capital Partners Enhanced Income Fund (REIF).

The main thing that struck me when meeting with planners is that many investors still believe that you cannot lose money with property.

This certainly isn’t the case. I recently bought a house for around 20 per cent below what the previous owner paid for it three years before — and this unfortunate owner had also invested a considerable amount of capital into renovating the property.

Although it was a win for my family, no planner wants to see their client’s money going backwards.

Spotting a good property investment seems to be becoming more difficult, but there are a number of fundamentals you can look for that help reduce the risk of a losing property investment.

So where do we think some of the best opportunities to find this vital combination will exist in 2007?

Healthcare

Australia’s ageing population is opening up a number of opportunities for property investors.

Medical properties, namely hospitals and aged care facilities, typically provide strong yields and prospects for capital growth as these sectors become a more mainstream property class.

Generally, medical facilities in regional areas do not have the same potential for capital growth as their metropolitan counterparts, simply because of infrastructure and site scarcity in the cities.

However, the so-called ‘sea change’ that characterises many in the ageing demographic changes this as many regional facilities are already operating at capacity levels and will increasingly be in demand from this group.

Industrial

Australia’s current cycle of economic growth is expected to continue in 2007, although at a slower pace.

The micro and macro factors of high wages, high employment, high levels of infrastructure spending and the much-lauded mining boom have continued to provide a favourable economic backdrop for non residential property sectors.

Looking specifically at the industrial sector, we believe there are good opportunities to be found, particularly in warehousing and distribution facilities.

However, as with all real estate investment, it is important to focus on the fundamentals of the particular property, rather than just choosing something because you favour the sector as a whole.

When selecting these types of facilities, you should look for those that sit on major supply chains — road, rail or port. This is because of the strategic importance of these facilities to major distribution and manufacturing companies, which will help drive demand for the property.

In addition, industrial property land values are typically lower than office, residential and retail uses. On this basis, well located industrial facilities often benefit through changing in zoning or through urban expansion.

Thinking globally

Of course, no one can really talk about investing in property anymore without looking at global opportunities.

Global real estate securities provide attractive portfolio diversification and open up a wide range of investment opportunities as this sector expands.

According to a joint report from SG Hiscock and LaSalle Investment Management, the global real estate securities market is in a growth phase.

The global investable universe offers depth, liquidity and an expanded pool of relatively undervalued investment opportunities.

The returns (in local currencies) from global property have outstripped those of global stocks and bonds, with property returning 24.1 per cent per annum over the past five years, compared with just 8.3 and 3.6 per cent per annum for stocks and bonds respectively to October 31, 2006.

Looking more closely at the different regions, LaSalle believes growth prospects for US real estate investment trusts (REITs) are particularly favourable. Operating fundamentals showed strong improvement in the second quarter of 2006. Cyclical recovery in real estate fundamentals is driving improved top-line revenue growth. Expanding investment management and development activities are also contributing to a favourable growth outlook.

In Europe, LaSalle expects strong earnings results and forecasts driven by a combination of increasing gross domestic product growth, recovering market fundamentals, same-property rental growth, attractive external growth opportunities (such as development, joint ventures and funds management) and solid capital structures and financial flexibility.

It also expects:

~ a number of existing listed property companies in the UK to convert to a REIT structure thanks to regulatory changes on January 1 that were more investor-friendly than had been anticipated;

~ REIT legislation to be introduced in Germany during 2007; and

~ expansion of the market in France due to a change in French SIIC (REIT) laws.

In Asia, Japan is witnessing a real estate recovery with improving fundamentals.

Central Tokyo office vacancy rates continue to fall. Healthy rental growth is now being seen, particularly in the office sector. Improved fundamentals and weak relative stock performance for Japanese REITs have created select opportunities in an otherwise fully priced sector.

In Hong Kong, office rental growth has been significant and LaSalle expects to see it continue, which should lead to substantial reversionary income growth.

The Hong Kong retail market also continues to improve and more Hong Kong REIT initial public offers are expected, however quality research is required to identify the best opportunities.

Fund inflows towards new international real estate securities investment mandates continue to look strong. Global pension (superannuation) funds are now emerging as important participants in the REIT sector.

Further, the merger and acquisition activity that the sector is experiencing is also providing attractive supply/demand characteristics for the sector.

A potential risk of this activity is that previous strong returns are now reducing, causing outflows from broad market and yield-oriented investors.

Direct property

As the market moves through its cycle and new opportunities present themselves, we will have an investment bias towards different property sectors.

However, whichever way the market moves, there is one criterion for unlisted investment that never changes: each unlisted investment must be able to achieve a total return that is commensurate with the risk of the underlying property portfolio — otherwise, we should just invest in a listed property trust (LPT).

Unlisted property trusts have produced strong returns in the past five to eight years, although investment margins have considerably tightened. This tightening favours institutional players and high calibre operators such as Investa and FKP, which can deliver a total return to investors.

Many unlisted trusts are purely yield focused. Not surprisingly, we avoid these trusts as we invest for total return. We maintain the premise that if we cannot secure a total return, then we buy a LPT instead, or, alternatively, hold cash and wait for the right opportunity.

The current LPT market

The ASX property trust index is producing 6 per cent yields, which is in line with many cash rates. We are underweight on the index as we believe there is potential capital volatility, so we instead overweight our income rich Active fund, where a sustainable higher yield can be found.

Paul Nielsen is the fund manager for Real Estate Capital Partners.