How direct property is cleaning up its act

During the GFC, direct property had a number of issues related to manager capability, asset quality, illiquidity and gearing. However, the sector has been working hard to address its shortcomings, writes Freya Purnell.

Australian direct property is attracting suitors from around the globe, with a number of different categories of institutional investors attracted by what this asset class has to offer.

Among the buyers are Singapore real estate investment trusts (REITs) such as Ascendas, K-REIT, YTL Starhill Global REIT and CDL Hospitality REIT, which are buying property to be housed in REITs and listed on the Singapore stock exchange.

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“They are able to make yield-accretive acquisitions in Australia – they can borrow at 2 per cent in Singapore and buy in Australia, so it’s a great carry trade for them,” says Andrew Cannane, head of corporate client services with The Trust Company.

Regional sovereign wealth and pension funds such as China Investment Corporation, Malaysia’s Employee Provident Fund, Singapore’s GIC and the Korean National Pension Service are also buying direct stakes in property – either in consortia, separate account mandates or directly.

But the biggest push is coming from global private equity firms with headquarters in South East Asia – including Aviva Investors, Blackstone, Goldman Sachs, LaSalle, Heitman, Grosvenor and Pramerica – “all buying property in Australia to fulfil global account mandates for core prime property,” Cannane says.

“They have been extremely active.”

Not to be forgotten are the Canadian pension funds – with the CPP Investment Board recently buying a 50 per cent stake of Northland Shopping Mall, and PSP teaming up with GIC to privatise the Charter Hall Office REIT.

“There has also been a significant amount of platform acquisition – you’ve had the likes of ING Industrial Fund privatised by the Goodman consortia, you’ve had Blackstone take out Valad, Trinity take out LaSalle, the Charter Hall Office REIT privatised, Red Cape taken out by Goldman Sachs, York and Varde, MSREF by Orchard, and even confirmation that Ascandas and Accor have bought the Mirvac Wholesale Hotel Fund,” Cannane says.

This enthusiasm for Australian direct property certainly seems unmatched locally – which Cannane attributes to a sense of pessimism that foreign investors don’t see.

“I think they are able to extract themselves from the day-to-day and focus on the fundamentals, which are still very strong.

"They are seeing unemployment less than 5 per cent, GDP [gross domestic product] at 3 per cent, vacancy rates all sub-10 per cent and yields holding up extremely well – they are seeing Australia as a great place to invest,” he says.

So why are Australian investors still so shy of direct property?

As Atchison Consultants managing director Ken Atchison points out: “The actual property market itself in the commercial areas of office, retail and industrial has been reasonably stable. The issue for investors has been with the investment managers.”

As in so many other areas of the investment markets, the GFC has left a lasting legacy on this segment.

The train wrecks that littered the direct and listed property landscape – including Centro, MFS, Opus, Orchard, and Becton – are not easily forgotten by investors, leading to ongoing caution.

“People are quite wary about whether the manager is capable of delivering on the investment proposition,” Atchison says.

The current global uncertainty certainly isn’t helping matters, and equity has been hard to come by.

Kevin Prosser, research manager, direct assets at Lonsec, says equity raisings for direct property funds have been down significantly over the last few years, with $155 million in capital raised in 2010 compared with $460 million in 2009. This rebounded slightly to $180 million in 2011.

On the upside, Prosser believes there are much more clear-cut investment propositions that have the potential to come to market.

“Fund managers have made the move to clearer structures, there’s not as much smoke and mirrors, and a lot of the banks are coming to the party in terms of their margins – we’re back to levels that aren’t profiteering,” he says.

“So those factors mean that people can put deals together if they think they can raise the equity.”

However, Prosser says although managers are clearly trying to get projects off the ground, many don’t come to fruition because of issues with bank funding or equity raising.

While some of the open-ended funds are renewing or raising new equity to expand internally or purchase additional assets, new offerings are in the minority.

Atchison believes that very few new direct property investment opportunities have come to market because of the reluctance of platforms to support syndicates, due to liquidity issues.

“That makes life very difficult for investment managers in creating products that will suit investors. Platforms are saying syndicates no longer work – I’m not convinced that investors share that opinion, but if most of your investors are on-platform, then it can’t be done,” Atchison says.

However, there are perhaps some small signs that things are starting to change, with the latest round of interest rate cuts shifting the focus of investors from term deposits to higher-yielding propositions.

“For investors that were putting all their money into term deposits and getting 6 per cent, that’s now down to 5 per cent. All of a sudden a commercial property that’s yielding 7 or 8 per cent is a bit more attractive,” Atchison says.

Over the last six months, the capitalisation rates for quality assets have stabilised and are actually firming, though B-grade properties remain stationary, Prosser says, largely driven by international and institutional investors.

Robert Olde, president of the Property Funds Association, which represents the unlisted retail and wholesale property fund sector that has around $36 million in investor funds, adds that flows to unlisted wholesale property funds are now surpassing those to listed property funds.

“Right now you should be looking at an effective hedge against the uncertainty that we are seeing in the Australian and global equity markets,” Olde says.

But retail investors are not necessarily buying it.

“A lot of the mum and dad investors, they are not coming back yet to the market. We are seeing it in the sophisticated wholesale market – they are putting their funds into direct property. But I think that’s the indicator and the driver for the retail space to get confidence and start to come back,” he says.

The clean-up crew

There’s no question the sector has had to clean up its act and improve the quality, transparency and risk profile of what it is offering to win over banks, investors, and even investment managers, who were reluctant to repeat past experiences.

During the GFC, there were issues with manager capability and asset quality, but the two biggest problems were gearing and liquidity.

Olde says among PFA members, gearing ratios are averaging around 45 per cent in the retail space and 16 per cent in the wholesale area – though some might argue that gearing levels are being dictated by lenders who have drawn a line in the sand.

Richard Stacker, chief executive officer of Charter Hall Direct Property, also says leverage in direct property funds is now much more likely to be in the 35 to 50 per cent range, with much higher-quality assets and distribution focused on real income.

On the issue of liquidity, he says there were definitely mismatches previously.

“The distributions that people were paying were probably more than the actual income or cashflow coming from the properties. They were offering liquidity in what was probably an illiquid asset class, in the short-term anyway,” he says.

Olde says while fund managers in direct property accept the liquidity limitations of the asset class, they now have to ensure investors recognise and accept those limitations as well.

“We are not going to be pushed back into providing liquidity mechanisms when we know they don’t exist.

"Our fund managers absolutely recognise that we have to be completely transparent and honest with our asset class. For investors and managers, our space has realigned our investment offerings back to the core strength of direct property – and that is that they are illiquid.”

Olde says that while illiquidity is often framed as a negative, its advantage is actually the “steady as she goes” quality – the perfect antidote to the volatility of equities.

“Part of what we need to achieve now is a re-education that you have to accept the illiquidity if you want the stability. We are not there yet.”

Pros and cons of direct property

Property generally ticks the box of having a low correlation to other asset classes, but the key selling point for direct property at present is yield.

And at between 7 and 9 per cent with some tax deferral benefits on top, it’s not to be sniffed at.

“It’s paying close to 100 per cent income, so it does have a very good yield when you compare it to term deposits, with the spread 3 to 4 per cent above term deposit rates,” Stacker says.

“That’s certainly before you take into account any type of growth that might come through off the back of rental increases.”

Another point in direct property’s favour is the lack of volatility compared with equities or even listed property.

“They are investing in the same thing, except with listed properties you are open to vacancies and what happens in the market, versus with an unlisted property, what people are going to pay for the initial asset and what happens to the valuation,” Stacker says.

While the downside of a direct property investment is its lack of liquidity, with funds usually requiring a five- to -seven year commitment, if investors are allocating no more than 10 to 15 per cent of their portfolio to the asset class, liquidity should not be an issue.

But gaining access to these investments in the first place might be. Without $10 million-plus up an investor’s sleeve, it’s impossible to DIY, so they have to choose a managed fund – either a diversified option or a single property fund.

Many of those interested in direct property funds such as those offered by Centuria Property Funds, according to chief executive officer Jason Huljich, are high net worth investors going direct, which accounts for around 30 per cent of their enquiries, with the remaining 70 per cent coming through planning groups and private banks.

Stacker says Charter Hall has seen interest from “early adopters” over the last two years, with larger dealerships, boutique advice groups, and sophisticated direct investors getting on board.

“The average investment is a lot higher than we have seen historically,” he says.

“The sentiment is improving. Particularly after the last rate cut, people are now just starting to focus on that yield proposition that it provides.”

Huljich says investors are currently interested in “commercial and some value-add industrial” property, but they are also showing a clear preference for single-asset funds.

“They like the simplicity and transparency of that structure – they know the building they are investing in, the tenants and the risks, instead of being in a big diversified fund.”

And in fact, of the few new funds that are coming to market at present, several are of the single-asset variety – for example, the Cromwell Ipswich City Heart Trust, a single-property syndicate for a commercial office/retail building in Queensland, and the Charter Hall Direct 144 Stirling Street Trust, a syndicate for an A-grade office building in the Perth CBD.

Atchison says these types of syndicates are being brought to market and raising capital, but they are still thin on the ground, and they are raising much less than in the past.

“We are talking $50-$100 million in capital raisings, not the billion dollars that was being raised in the past,” he says.

As an off-platform investment, syndicates are most likely to attract self-managed superannuation fund (SMSF) investors.

Direct property fund managers like Centuria and Charter Hall are also seeing strong interest from SMSFs, with 60 per cent and 80 per cent of their investor bases respectively being SMSFs.

Stacker says they are also seeing both more SMSFs investing, and an increased amount of investment on a year-on-year basis.

What’s ahead

Despite the sluggishness affecting the direct property sector at present, most are optimistic the solid fundamentals will bring this asset class to prominence.

Olde believes the wholesale market leaning more towards direct property funds at the expense of listed property trusts is a good sign that the retail investor will also be won over about the sector’s outlook.

“On the market dynamic side, we are going to see less pressure on the investment markets going forward.

"We have got a strong resource sector which has pulled the investment market through, and going forward, it’s going to be a huge opportunity for the construction of A-grade and B-grade offers in commercial properties to absorb all that demand,” Olde says.

However, Stacker sounds a warning that investors should select carefully before jumping in.

“We are definitely in the market now where not all property is doing well. It is very market-specific.”