In uncertain times there’s something to be said for sticking to the familiar. And for Australian investors surrounded by global recession and a share market that continues to struggle for normalcy, Ken Atchison, managing director of Atchison Consultants, believes there is ample reason for sticking to the familiarity of direct property and the reassurance of a bricks-and-mortar style income.

Both sides of the fence

Comparing direct property with its counterpoint listed property trusts (LPTs), Atchison said that, in terms of value, both sectors were looking attractive.

“Listed property, both international and domestic, has been taking an absolute hammering recently,” he said. “So does the sector represent value? Yes, it does.”

“But listed property is anticipating some pretty savage revaluations of its underlying assets. So any listed property with high levels of debt is still going to have a limited upside.”

Within direct property, Atchison said that while valuations had already been priced into listed property, the less frequent valuations that were normally an advantage for unlisted property assets were yet to occur.

“That means there’s still some downside, but if we’re looking at an economy that is starting to see the end of its dislocation, then cap rate yields are at high single digits and the fundamentals are relatively okay.”

From the adviser perspective, Neil Kendall, financial adviser at Tupicoffs Financial Planning, said the advice Tupicoffs had been giving clients was that those with larger portfolios should be retaining a direct property component within their overall allocation.

“With respect to property acquisitions, we’d advise investors to avoid anything except fire sale commercial property,” he said. “But we’d advise caution within the rest of the market as well.”

“They should only be buying where there’s a guaranteed income for the next 10 to 15 years because we see tenancy management posing a number of difficulties for the next little while.”

Paul Little, financial adviser at Landmark Financial Planning, said he could see two views emerging within direct property investment.

“Retail investors have always been interested in direct property,” he said.

“Interest spikes when other markets underperform and that hasn’t changed. Direct property is still seen as a safe haven by many investors.

“But I’m also sensing a consensus among retail investors thinking that the outlook for direct property might not be so rosy,” Little continued.

“There’s a view that with tough economic conditions, previously inflated prices, changing interest rates and changes to the first home buyer’s grant, there is reason for caution.”

But for investors seeking the reassurance of a bricks-and-mortar investment and for more secure, less volatile returns, direct property continues to have a place in portfolios.

“In so much as it provides peace of mind, direct property continues to fulfil that role,” Little said. “People tend to sit on direct property investments for long periods of time, until they can make a gain out of it. So on that basis, little has changed.”

“However, if people’s circumstances have become a bit tougher and there’s been a need to sell their direct property assets, they haven’t seen the security they might have been expecting on initial purchase,” Little added.

“If they’ve been forced to sell and to take whatever they’ve been able to get, that safe haven hasn’t been there.”

Kendall urged investors to be very cautious of how much reassurance they were drawing from the supposed safety of direct property.

“People have to be very careful because direct property is likely to be the next in line to feel the full impact of the financial instability other markets have already experienced.

“We’ve already seen a reduction in prices, but changes to the first home buyer’s grant may mean that the cheaper end of the market will feel falls that it has so far been protected from,” Kendall said.

“And if the economy continues to deteriorate, we may see tenancies decrease and prices dropping further.”

Financial crisis hits home

For Kendall, the choice between direct property and LPTs has not necessarily been made easier by the financial crisis.

“It comes down to a timing issue,” he said. “Listed property has seen massive falls but because direct hasn’t fallen, it has a lot more upside potential.

“It will have made a huge difference whether people took a 50 to 60 per cent hit on LPTs or whether they were able to buy in at the bottom of the market.”

Steven Lawford, portfolio manager for APN Funds Management, suggested there was a downside to be felt on both sides of the equation.

“It’s a tough one,” he said. “Many people in unlisted funds may have been hurt by a lack of liquidity, but on the other hand, those in listed property will have been hurt by significantly increased volatility.

“Depending on the type of investment and when those investments were made, some will have both listed and unlisted property in their portfolios that aren’t performing well,” Lawford said. “But in most situations that poor performance will have been due to gearing, and it means that, going forward, there are likely to be some great opportunities in lowly geared direct property.”

Gearing down

Of course, it wasn’t that long ago — before investors were forced into the reality of a global financial crisis — that gearing within direct property had proved successful enough to have become almost common practice.

Yet times have changed and Kendall believes investors have become very focused on gearing’s downside.

“Investors are now very focused on the downside in anything they’re investing in,” he said. “That’s been mitigated with the cost of gearing dropping so dramatically, but it’s likely to remain a concern.”

For Lawford, this concern is that investors’ gearing consequences are still working their way through the system.

“Investors may no longer be making the same mistakes,” he said. “But with the gearing levels that direct property has reached over the last few years, I think the market is continuing to feel their impact.”

According to Little, with lower interest rates on offer, the timing could be right for investors interested in higher levels of gearing.

“The issue with direct property is that it’s pretty difficult to get into the sector without some level of gearing,” he said. “But people aren’t necessarily going into it for the gearing that it can provide.

“If you’re invested in direct property, you’re there because it’s your preferred investment.”

Little added that inside or outside of a financial crisis, people would always make gearing mistakes.

“But there is also a degree of caution out there at the moment,” he said. “And one element of that is the jobs outlook and people’s uncertainty around their employment situation for the next 12 months.

“The banks have tightened up their requirements and that helps protect people from themselves, but we probably aren’t seeing any more gearing mistakes than usual,” Little said.

“There are always going to be people who overextend.”

Managing liquidity

Yet beyond gearing, Kendall said that the other key lessons to come out of the global financial crisis for retail investors, and one shared by institutional investors, could be one of liquidity management.

“For retail investors, the availability of liquidity has had a limited effect but it will have a greater effect moving forward,” he said. “Banks have already started to ration their lending and limit credit availability.

“It’s something people are chronically aware of because liquidity has been vastly underrated for some time.”

Little said that regardless of whether they had found liquidity a concern, investors’ understanding of the issue had grown significantly.

“If they’re concerned about their job circumstances or if they can see a need to shuffle their financial arrangements in the near future, then they are certainly coming to understand the importance of liquidity,” he said. “But it is still a feature of portfolios that is generally undervalued.”

“When people go into illiquid assets, they don’t often ask themselves how much more return that asset should be giving them to make up for its illiquidity,” Little continued.

“Most property investors are long-term investors, so unless they’re under significant pressure, that concern might not be there.

“But for others, it’s a question that isn’t asked often enough.”

Risk and security

Looking at the property sector, Atchison said the tried-and-true formula for property investment, whether direct or listed, continued to be the retail, industrial and office sectors.

“That hasn’t changed,” he said. “But interestingly, I’d say that office property has the potential to be amongst the riskiest sectors.

“It’s standing up well because the supply side isn’t storming the market,” Atchison said.

“Rents aren’t collapsing and provided we’re talking about a quality property with secure tenants, the sector is generating income and performing relatively well.”

Also seeing risk in the commercial property sector, Kendall said the silver lining was that many properties were now selling at huge discounts.

“It’s the sector that has probably performed worst over the last 12 months,” he said. “And though there are some great deals out there, investors and advisers will need to be careful.

“There’s great upside potential, but there’s also a chance that the sector’s recovery will be slow.”

Agreeing with Kendall, Little said that he saw most clients looking to opportunities within the commercial sector for their next direct property investment.

“Most are looking at commercial property with good strong yields and long leases,” he said. “And if they can sit on that for five to seven years, any capital growth is a bonus.”

Interestingly, Lawford said that at the direct level, industrial property had probably been worst hit by the struggling economy.

“The retail and office sectors remain the best performers,” he said. “But at the end of the day, it’s about the security of the tenant and the security of the income stream.

“Those two things are far more important than the sector in which the asset is held.”

Yet the challenge for retail investors goes beyond picking which property sector is likely to perform best. Given what property and wider investment markets have experienced in recent months, the more burning question is where direct property should fit into their portfolios.

Understandably, Kendall believes the answer is very client-specific.

“The reality is that clients with less than $1 million will find direct property exposure difficult,” he said. “The assets aren’t liquid enough and you really need to be buying large chunks of an individual property.”

Similarly, Little said the answer came back to the investor.

“By nature, property tends to be illiquid,” he said. “It has a role to play in portfolios if you have enough assets that a sizeable portion can be devoted to investments that lack liquidity.

“If that’s the case and if it provides returns above what could be gained from a liquid asset, then direct property can be very beneficial,” Little added.

“Unfortunately, there aren’t too many people in that situation.”

Income streams

It seems that within an uncertain investment environment, the most common appraisal of direct property has been that, with a good location and high quality tenants, rents and therefore income streams have been holding up well.

Yet Kendall warned that a complicating issue could lie in those same high quality tenants.

“They may have been high quality tenants in the past but if they’re also feeling the pinch, there’s a chance that could impact normal income streams.”

For Atchison, liquidity and its impact upon property investment has been the most disturbing feature of the past 12 months.

“People have seen property as not liquid,” he said. “And their response has been a tendency to focus on just liquid investments.

“But property’s fundamental rules will flow through when sentiment returns. So with baby boomers already entering retirement and wanting retirement income, the income-generating qualities of property should again come to the fore.”

Reflecting on whether direct property investment had experienced changes in the past 12 months that were likely to go beyond the short term, Little pointed out that property cycles tended to be much slower than those within other markets.

“Three months ago, people attending auctions were saying that if they didn’t buy today, then buying would be more expensive tomorrow,” Little said.

“Now, with high unemployment, changes to the first home buyer’s grant and a struggling economy, they’re expecting those prices to be cheaper the next time around.”

“Looking ahead, I’m expecting that physical property prices will be much more closely linked with economic performance,” Little added.

“But investors have certainly sensed a change and by simply sensing that change, it could become self-fulfilling.”