Direct property sector reaches crunch time

The Australian Association of Independently Owned Financial Planners’ launch of a class action against Challenger for the failure of its Sydney property fund comes complete with the castigation by its executive director of direct property as a whole.

Peter Johnston believes the failure of the Challenger Howard Property Trust — Penrith Homemaker Centre (see story on page 1) was not the first or the last failure we will witness within the direct property market.

“In fact, I have been employed in the financial services industry since 1979, and 99 per cent of all problems that have occurred in the sector have been through unlisted property collapses.”

Johnston gave credence to his comments by “rattling off” a long list of major direct property fund crashes preceding Challenger that were “related to bad management of an underlying property, over-gearing or negligent valuations”.

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“There was the Telford Property trust in 1985, followed in the early 1990s by, among others, the Australian Fixed Trust, Estate Mortgage, the Family Security Friendly Society Property Fund (it went under), and then Westpoint and Challenger.

He added for good measure that he “personally would not get involved with any unlisted property trust in future, unless it was totally analysed by professionals”.

Property cycle

“What traditionally happens is at the beginning of a property cycle everyone makes money on these funds, but people get greedy by the time it reaches the middle of the cycle and a second property is purchased.

“Unfortunately, by the time this second property reaches fruition, the market’s turned and they can’t sell their apartments or they heavily discount them, and the troubles start to accumulate.”

Johnston told Money Management that ultimately the only way to clean up the unlisted property funds sector was for the Federal Government in the form of Australian Securities and Investments Commission (ASIC) to take over regulation of the sector from the state governments.

“Regrettably, however, we have been told directly by Parliamentary Secretary to the Treasurer Chris Pearce that any move against the states would be unconstitutional without this been sanctioned in a national referendum.”

Supply boom

Industry spokesmen for the direct property market were quick to defend the sector and their own investment performances, and to take Johnston to task for generalising across the entire retail, office and industrial sectors.

Johnston did, however, find some sympathy for his sentiments in a sector that is growing rapidly and, analysts say, has seen a huge amount of additional product come into the (retail) space over the past 18 months.

This includes funds set up by new entrants, wholesale fund managers offering retail products, and what were traditionally property syndicators trying to move up to a full funds management role.

Century Funds Management (CFM) managing director John McBain, for example, said he would “not respond negatively” to Johnston’s comments, as he is “probably correct in a very general sense”.

McBain has good reason to contest Johnston’s comments, as the privately-owned CFM, with approximately $440 million under management, was only this month acquired by OFM Investment Group (OFM).

“Sure,” he told Money Management, “if you really wanted to you can demonstrate that there are some managers of unlisted property funds who possibly aren’t doing their job as well as they could.

“By the same token, if I really wanted to I would also be able to point out with ASIC’s help a large group of financial advisers who possibly aren’t doing the best job they could for one or other reason.”

McBain explained that the fund failures called by Johnston were “all set up in the 1980s, allowing investors to redeem at will. Quite clearly, it’s impossible to have a total illiquid asset and then offer total liquidity to investors in the security.”

He said he personally “would not have bought the Challenger property because of the investment risks, not even when it was sold at a discount of 30 per cent or 40 per cent of its original purchase price”.

“Of course, I don’t know whether those risks were set down in the offer document, whether independent research picked up those risks, or whether they were transmitted to the clients of advisers.”

He added that it’s “equally ludicrous for any planner to advise a client to go into a product where these risks have not been set out, and then turn around and blame the product when it fails”.

“Similarly, if a planner advises an investor to invest in an equity, and it drops 30 per cent, then I don’t think you could automatically presume that fund managers haven’t done their job properly.”

It worries McBain that Johnston could make the caveat that he’d like to see independent research before he would invest in an unlisted fund.

“Does this mean that he’s seen a lot of advisers putting money into products that are not independently researched, and then was surprised that the results might not have been optimal?”

Crunch time

Tony Pitt, managing director of 360 Capital Group, which was launched earlier this month, also believes there will be more of the Challenger type-assets, or secondary type assets, that will fail over the next two years.

“You do have a lot of new product being created in the unlisted sector, but some managers will find it very hard to meet the returns they are promising.”

He bases his opinion on these managers “often not looking at the underlying property fundamentals in their eagerness to bulk up their portfolios”.

Pitt, who resigned from James Fielding Funds Management to launch the boutique funds manager, is also predicting significant consolidation in the sector as a lot of the earlier property syndicates reach their expiry dates in the next thee years.

“What you’ve had is mainly finance guys, without too much property experience, setting up these syndicates, and it is now coming to crunch time.

“They are finding that they can’t continue to manage these syndicates from a property play, whether it’s expiry or redevelopment, for example, so now you are getting more of the direct property guys coming in there and playing in that space.”

To give an idea of the “quantum” of syndicates expiring, he said, in 2007 this will amount to about $1.2 billion, and in 2008 to about $2.4 billion.

“These managers will all have to go to unit holders with a decision on whether to keep their fund open, close it, sell the assets or whatever.”

PIR Independent Research Group director Mark Wist said Johnston’s comments should be measured in the context of it being in the best interests of investors to gain exposure to property in a balanced portfolio.

“The question is whether exposure to LPTs [listed property trusts] is exposure to property, with some experts arguing that the fundamental drivers are often not that closely connected to the performance of the underlying property.”

By contrast, Wist said, when you invest in direct property your fundamental performance is “driven by the performance of that property and not by sentiment in the equities market or by stapling opportunities of the LPTS”.

Rapid expansion

He added that Johnston’s comments ignore that the unlisted funds sector (retail investment) has grown at an average 40 per cent a year over the past 10 years, and that funds under management (FUM) now exceeded $17.1 billion.

This rapid expansion has primarily been fuelled by the weight of inevitable funds seeking exposure to property, which in turn has grown substantially, due largely to compulsory superannuation, he said.

“The introduction of the Managed Investment Act may also have assisted in this growth by enhancing the perception of property (and securities) as a relatively secure investment, as has increasing independent research in the sector.”

He acknowledged that initial yields have been “falling steadily since 2001 as a result of this excess demand, but capital gains have increased to offset the decrease in distributions, resulting in relatively stable total returns”.