Will falling interest rates bring back investors?

Learning the lessons of the past, the local listed property sector is now much more inclined to ‘stick to its knitting’ – giving up tricky corporate earnings strategies in favour of focusing mostly on collecting rents, holding only domestic assets, and offering decent yields. But it hasn’t been enough to bring retail investors back to the sector in numbers. 

“Based on inflows into Australian real estate investment trust (A-REITs) funds, you have to say that sentiment is pretty flat, and that hasn’t changed much over the last 12 months,” says Michael Doble, chief executive real estate securities, APN Property Group.

“We understand that investors are still putting their money into fixed interest and cash products, and they account for around 25 per cent of the average retail investor’s investment profile. That comes at the expense of other active investments, and listed property is one that is suffering.”

Managers are finding that advisers and clients are still harbouring mistrust towards listed property, and are not necessarily swayed by good news about the sector’s characteristics, according to Morningstar research analyst Mark Laidlaw.

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“It’s a lot more sustainable, but at the same time, people have a long memory of what happened in 2008, so that is holding them back from getting back into the sector,” he says.

Financial planner Paul Kearney, principal of Securitor practice Kearney Financial Planning, agrees that the level of caution towards the sector has dramatically increased, but says his practice is now dipping its toes back into the water after opting out for the worst of the volatility.

“We have gradually moved back to a neutral position after being seriously underweight,” he says. “We think it offers good returns, it’s just that you have to be really sure about the managers you choose,” he says.

Even in the institutional market, it seems to be a case of ‘once bitten, twice shy’, Doble says, with direct property favoured more than listed. 

But Mark Ferguson, senior portfolio manager and head of listed real estate at AMP Capital Investors says institutional investors have helped to drive the recapitalisation and transformation of the A-REIT sector post-global financial crisis (GFC).

“Smart institutional investors are seeing A-REITs as being very defensive, particularly when you have got earnings uncertainty in the broader equity markets,” he says.

Simon Hedger, senior portfolio manager at Principal Global Investors agrees, adding that institutions are being attracted by its yields and diversification benefits, given the low-growth environment more broadly.

“Listed property is overdue some improved sentiment going forward, but certainly among the institutions, we’ve noticed that they have been increasing allocations off a fairly low base,” he says. 

A-REITs delivering the goods

Return-wise, local listed property has had a good year. The A-REIT sector has delivered a total return of 11 per cent over the 12 months to the end of June 2012, while for the six months to the end of June, returns were 16.4 per cent. The A-REIT market also outperformed the global REIT market, as measured by the UBS Global Property Investors Index (AUD hedged), by 5.6 per cent over the year to June 2012.

Average yields for the A-REIT market are also typically sitting in the 6 to 6.5 per cent range, and managers expect these to be maintained, with gearing around 30 per cent on a debt-to-asset basis. 

Ferguson says what he finds impressive about the sector is that the strong returns and solid yields are being delivered on a payout ratio of 30 per cent. 

“For investors, it’s fairly secure yield, and when you compare that to what’s happening with bank deposit rates, 

A-REITs are going to remain fairly attractive in a low return environment,” he says.

But while the numbers are looking good, financial planner Paul Kearney, CEO of Kearney Financial Services, sounds a note of caution – yes, the performance is there, but the returns have been made from a very low base.

“It’s not that the sector has performed magnificently, it’s that it has come from a position where no-one had a lot of faith or trust in it. That’s returning, and we’re starting to get back to normal valuations,” Kearney says. 

Using listed property in a portfolio

Many of the problems with listed property during the GFC were caused by funds being over-leveraged and over-engineered, and in the case of the 

A-REITs, investing offshore and getting too far from what they knew. Since 2008, many funds have had to recapitalise, and in the process have returned to their traditional structures and reduced gearing levels to below 30 per cent. 

“The companies have got out of all those non-core activities, and brought the gearing down through raising equity and selling assets to a level that is manageable and sustainable,” Hedger says.

Doble adds: “Now we really have a genuinely low-risk sector where there is not much offshore investing, there is a lot less active, corporate-type earnings coming out of the sector. They were ultimately seen for what they were – risky business investments. Because of that, the price is being paid by some management teams throughout the sector.”

Matthew Wrigley, senior associate in the Financial Services and Structured Assets team at Baker & McKenzie, Sydney, says that a focus on real transparency has also emerged.

“Managers have made a real effort to inform the market of their strategies, which they have not always done,” he says. “You have seen a lot of players respond to what the market has demanded, and that’s to get back to what they do best.” 

He points to GPT focusing its activities domestically, Stockland and Mirvac exiting non-core sectors, and Westfield undergoing strategic restructures as examples.

“Certainly, clients we are engaging with are focused on making their products attractive to retail investors, with lower fees, more incentivised performance, more alignment – these are all good things and hopefully it does translate into increased investment,” Wrigley says. 

With this return to low-risk philosophies, the emphasis is back on listed property’s traditional role in the portfolio – to provide secure and steady income. In addition, listed property also offers the benefit of liquidity, and inflation protection in the medium term.

“If you take Westfield, for example, two-thirds of leases in Westfield shopping centres have annual reviews which are CPI-linked. So effectively, you are hedging out inflation risk,” Hedger says. 

Nathan Bode, associate, fund services, S&P Capital IQ says that listed property will continue to deliver “more equity-like” returns than its direct and unlisted counterparts, and that therefore REITs should be part of the growth allocation of a portfolio. 

But Kearney believes this type of volatility could be a red flag. 

“Even though it’s a sector that’s not quite defensive, it replaces low-yield cash investments potentially in a portfolio, so when it starts behaving too much like a very volatile equity, it’s not doing what it’s supposed to do,” he says. “It was behaving very much like pure equities back in 2006 to 2008 – returning huge capital gains as well as the yields it’s really designed to generate. We saw that that ended in tears.” 

He advocates keeping the focus on yield for listed property.

“What you are acquiring when you invest in listed property is a strong yield on your investment, which is hopefully growing over time as the underlying rents rise,” Kearney says. “Then there is capital growth out of that because the underlying asset value is rising as well. But don’t think it should be an equity proxy.” 

A-REITs vs global REITs: concentration or calamity?

For Australian investors keen to get into listed property, the choice is whether to stick with the A-REIT sector or jump into the much larger pond that is global REITs. Currently, both have fundamental issues.

Lonsec’s recently released annual review of the A-REIT sector found that concentration issues are still a problem. Most funds in the sector are benchmarked against the S&P/ASX 200 A-REIT Accumulation Index or the S&P/ASX 300 A-REIT Accumulation Index, and Westfield continues to dominate, with Westfield Group and Westfield Retail Trust the top two stocks and constituting more than 40 per cent of both indices.

The top 10 stocks in the ASX/300 A-REIT Accumulation Index make up a whopping 92 per cent of the overall index. In the global REIT market, there are 220 stocks represented in the benchmark UBS Global Investors Index ex-Australia, and the top 10 make up 30 per cent of the index – resulting in far greater diversification. 

“Australian institutional investors have really started to move from Aussie REITs into global ones because of the portfolio construction issues around Westfield, and because they have plenty of direct property,” says Grant Forster, chief executive, Principal Global Investors (Australia).

The A-REIT market also has issues with sector-based concentration. It is dominated by retail, at 53 per cent, and diversified trusts at 35 per cent, with the small remaining proportion coming from office and industrial.

On a global basis, the index is around 28 per cent retail, 26 per cent diversified and 23 per cent office, with the remainder made up of more diverse areas such as hotels, storage and healthcare, which are not represented in the A-REIT market at all.

Inadequate diversification in the A-REIT sector means that an index strategy is all but closed off to investors, with active management likely to be far more effective. 

While the small number of stocks reduces the number of clear mispricing opportunities which can be exploited by A-REIT managers, the diversity in the types of investors now holding major shares of the market – equity fund managers, hedge funds, and direct retail investors as well as dedicated A-REIT managers – should ensure that managers are able to find sufficient opportunities to generate returns, according to Lonsec senior investment analyst Sam Morris.

Doble argues that A-REITs are “categorically” more attractive for an Australian investor, offering a “relative sea of tranquillity” in terms of market risks, and minimising currency and information risk – that is, not understanding what you are investing in. 

“That applies to investment managers too – there are a lot of examples of local managers thinking that they can outsmart global managers based in New York or Hong Kong or London, who know their markets far better, frankly, than anyone sitting in Sydney or Melbourne ever will,” Doble says.

Despite offering a much more active and diversified marketplace, Laidlaw says global REITs have suffered from as little appetite as A-REITs in recent years. Back in 2008, hedging losses resulting from a slump in the Australian dollar wiped out their ability to distribute income. 

“One of the main attractions of a global REIT fund is the distribution that it can give – because that wasn’t on offer, interest in the sector waned,” Laidlaw says.

While that isn’t a factor these days, the turbulence affecting Europe is, particularly if the banking sector struggles and closes off credit available to property managers, which could cause the sector major issues, and across the board in the global listed property market, valuations are considered high. 

Laidlaw therefore recommends taking an approach that will deliver the best of both worlds.

“Typically, our preference has been towards taking global REIT managers who actually have Australia as part of their investment universe,” he says. “It allows you to get that credit diversification and ensures that you are not having that massive retail base if you have purely A-REITs.”

Ultimately, advisers and investors need to be very clear about what they expect from the real estate allocation – and the level of risk they are willing to take for the level of income they are after. Global REITs will add a higher level of risk to the portfolio and add the potential for capital growth, but with global REITs typically offering a yield of around 4 per cent, compared with the 6.3 per cent offered by A-REITs, there is an income trade-off. 

“Some investors will like the diversification benefits – particularly in real estate subsectors and markets not available within the Australian REIT marketplace – that global REITs provide. Others will be attracted to the higher yield, local currency exposure Australian REITs provide,” Bode says.

When it comes down to brass tacks, Kearney says that it actually doesn’t matter whether listed property funds are Australian or not, as long as the managers and assets are good quality.

“As it stands right now, our preferred listed property trusts are international, but that’s because they have the characteristics that we want, which is good solid performance over the longer haul, and a nice diverse range of assets underpinning it in the debt position where we want it,” says Kearney. 

What to look for: tips for choosing the right listed property investment

Choose quality property portfolios and managers. Find those who have the track record through recent boom and bust cycles, Ferguson says, particularly those who can “add value in terms of development expertise and how they run their property portfolios”. Kearney agrees: “Don’t just look at the most recent performance data – look over the history, particularly through the GFC, and see how they have performed on the basis of a few factors, not just return. You must look at the division of the underlying asset spread as well to make sure you are not buying into something that would get itself into lock-up if we went through another GFC. That’s what clients really hate.” 

Be wary of super-charged returns – strong and steady wins the race. “You’ve got to be wary of where they came from. You are not looking for the best performer in the last quarter – you’re looking for fund managers proven in their ability to generate solid returns through the cycle,” Kearney says.

Go for income, first and foremost. “The trap in property is being seduced by high growth strategies. Property should never be used in a portfolio to deliver growth, it should always be about low-risk income,” Doble says. 

When using listed property to provide income streams for retired investors – for example, choose defensively positioned vehicles. “One vehicle is not the same as the other just because it’s in the same sector,” says Kearney. “It’s all about how it’s geared and what the underlying assets are in. So you’ve got to be very selective about the portfolio you are buying into.” 

The unlisted alternative

With investors primarily concerned with liquidity and ease of access to their funds, listed property can offer this as a powerful advantage over the unlisted sector.

“We prefer our clients to play in the listed space unless they really know what it is that are getting. From an unlisted point of view, it’s buy and hold for a very long time, whereas listed is much more liquid,” Kearney says. 

The unlisted sector does offer investors greater diversity, less volatility and slightly better management overall, according to Doble; but on the downside, gearing levels are much higher.

He believes listed and unlisted property should be combined in the portfolio to optimise returns. 

“Our argument is always that you can’t really compare and say one’s better than the other – they both have their merits, and together they are powerful,” Doble says.

However, Ferguson says that on current valuations, it is still cheaper to buy A-REITs than top quality property in the direct market.

“When you look at implied cap rates – in other words, what the market is pricing – it is still sitting at some 40 basis points higher than stated book values,” he says. “If you look out a year ago, that differential was something like 100 to 120 basis points, so you can see how far that has come in.”

Global REIT market by region

Around the world, the top three markets for REIT performance over the past 12 months have been Canada, the US and Australia.

Wrigley says this is not surprising, given that economically the markets share similar traits. 

“From a real estate investment point of view, I see it as very defensive. In times of uncertainty, investors will flock to big, established, transparent markets,” he says. 

Despite the tumult in Europe, there is still value to be had in the region, according to Hedger, with specific markets like London, some Scandinavian countries, and German residential property offering growth opportunities. 

In Asia, Japan and Singapore are in positive territory, but the growth is very modest compared to the returns offered in Australia, Wrigley says. “Unfortunately for some of the regional exchanges that are built on growth, Singapore REITs in particular are not viewed as pure income products, but income mixed with growth. In the economic period we are in now, those types of funds will tend to underperform.”

An interesting recent phenomenon, according to Principal Global Investors (Australia) chief executive Grant Forster, is that while institutional investors might be able to access listed funds or direct property in the US or Europe relatively easily, they are finding it more difficult to get set in Asia.

“I think that will also drive institutional investors to have more in global REITs and possibly some of that going into Asian REITs.”

Emerging trends

While the listed property sector is probably in the “cleanest health” it has been in for a number of years, according to Laidlaw, there are still challenges ahead in terms of winning investors over and managing a slowing growth environment. Doble predicts that the trend to lower risk strategies will continue. 

“The other trend is earnings growth – slowly rising rents but also the benefit of lower debt costs is benefiting the majority of A-REITs,” Doble says. “Consistent with that are higher distribution payments and higher payout ratios.”

All managers in the sector must also face challenges around balancing optimum payouts with responsible management, particularly around costs. 

“We did see a blowout in salaries pre-GFC, and we are seeing that whole picture moderate,” Doble says. “Headcounts are being reduced and management teams are very focused on managing those costs.”

And while lower cost debt is providing some stimulus for acquisitions, the limited number of players in the A-REIT market presents an ongoing structural concern, says Laidlaw. 

“With only 19 names, that could go lower, and if it does, at what stage does the index become unsustainable?”