Property metamorphosis

The story of the unlisted property sector over the next few years will pretty much also be the story of platforms, these vehicles representing one solution to the sector’s illiquidity.

An issue for the past decade or so — demands by consumers for greater liquidity — has at last been realised in the emergence of unlisted property funds on platforms

A few pioneering unlisted funds are now offering a three-day liquidity facility, and as a result are now able to be offered via platforms.

It’s a small step for the sector in itself, industry sources say, but one that has the potential to impact enormously on both the unlisted property and platform sector over the next few years.

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In fact, liquidity is only one of a number of major trends and issues that have the potential to transform the way the unlisted sector operates over the next few years.

The new liquidity facility is an attempt to significantly drive retail investor demand for unlisted property, according to James Burkitt, chief executive of direct property group Pentacle Property Funds Management.

“A lot of the property fund managers recognise illiquidity as the single biggest reason financial planners and retail investors have not participated in any major way in unlisted property.”

Burkitt says it is one of the reasons the group has released a version of its Pentacle Diversified Property Funds offering the three-day facility. Some of the other pioneering managers offering fund versions with the facility include Centro Properties Group and Macquarie Bank, he says.

The new funds essentially “give a balance sheet commitment to repurchase the units in their vehicle”, a small act in itself, but one that was necessary for unlisted funds to be sold on platforms.

The master fund/wrap accounts on platforms have generally been prohibited from investing in the alternative spaces because their systems can’t handle any asset that has a longer settlement period than three days, he says.

“That’s why a lot of these have lagged the industry super funds — because they haven’t had hedge funds, private equity, infrastructure, direct property.

“Groups like us are trying to address that by offering liquidity, and I think that this facility will also serve to open up the whole platform market.”

Burkitt is predicting 5 per cent of the platform market will be invested in unlisted property over the next three years, up from zero currently.

“You have a $350 billion platform sector that has been growing at around 15 to 17 per cent per annum, and should continue to do so for the next five years, doubling its size to $750 billion.

“If 5 per cent of this is invested in unlisted property, as we are predicting, this will mean about $35 billion in unlisted property assets, which is about the size of the unlisted property market today.”

He described this as a “logical deduction, rather than special prediction, because the major super funds, excluding the platforms, have already got just over 6 per cent allocated to unlisted property”.

The “liquidity insurance facility has its limits and also its price, namely that clients will have to pay a small premium for it, say an extra .45 per cent over the management expense ratio (MER)”.

A lot of older clients, those who are “looking for high income but don’t want to lock in for seven years (the usual unlisted investment period)”, will be willing to pay that for the liquidity facility, he says.

Initially, the unlisted property component on the platforms would likely be mainly hybrid type funds, which have say 30 or 40 per cent in unlisted property and the remainder in listed property trusts (LPTs).

The trend towards platforms will be accompanied by “strong growth in offers of growth-orientated specialist unlisted property funds”, according to Burkitt.

These so-called ‘core plus’ funds aim at taking advantage of turnaround situations, in markets such as Japan (but also in Australia), where direct property is poised to pick up along with the economy.

He says quite a few of these core plus funds have already been launched by Australian property fund managers, including Macquarie, which has a Japanese fund, and more are set to folow.

The funds are typically characterised by investment returns that are low in terms of yield and high in capital growth, he says.

“They are for clients willing to take a lesser yield as property assets are repositioned, but are expecting a much higher capital growth.”

Burkitt prefers to call them ‘special opportunities’ funds, for the reason that they effectively “trade in turnaround property assets”.

The managers will “buy a building that is poorly tenanted and/or needs refurbishment”, in order to sell it on after doing a refurbishment and finding new tenants.

An example of this, he says, is the recent purchase by Valad Property Group of Goldfields House in Sydney, which was an asset Multiplex “needed” to sell.

“It’s an opportunistic asset in that it’s in a super-prime location that could either be refurbished as an office building or, if they could get a DA [development application], they could convert into an apartment block.”

As another example, he says Pentacle has invested in a fund manager that targets “transport infrastructure orientated real estate”.

“They have put a fund together for the new Epping to Chatswood railway line, from which, as a ‘re-zoning’ fund, you would expect very little yield but a lot of capital gain.”

He recommends exposure of at least 10 per cent in the ‘special opportunities’ funds in building a portfolio, with 30 to 40 per cent in international property, and the rest spread across the core specialist sectors or industry office and retail.

Yet another key emerging trend identified by Burkitt is the rise of specialist managers, such as Centro, Investa Property Group and Macquarie-Goodman Group, which aim to be the best in one investment area of the unlisted property sector.

In fact, Burkitt predicts this will become the “new investment model” for the unlisted sector, enabling investors to pick specialists that will outperform the big diversified managers”.

He says one of the drivers for the specialist managers is because the “asset allocation decision in a property portfolio makes such a huge difference”.

“Specialists are arguably better at managing shopping centres than a generalist who manages shopping centres, industrial, office and everything else.”

At the same time, he adds, it’s very hard to asset-allocate if you’re a manager of a very large diversified property fund, let’s say a $5 billion fund.

“For this fund to increase its office component by 10 per cent and increase retail by 10 per cent, they might have to sell a $500 million building.”

By blending a combination of investments, specialist managers “will be able to out-perform the sector, leading in turn to their growth in number, as has happened in every other asset class”.

By contrast, the large diversified funds “will increasingly be treated as passive direct portfolios” by investors, who, he says, in the main will “no longer be content to stick with a big boring fund”.

Investors are generally looking for “a more active allocation, liquidity, and diversification across geographic, sector and managers,” Burkitt says.

“They have come to expect that in every other asset class, after all, and we see them wanting that now in the unlisted property sector.”

However, he sounds a note of caution that there are a lot of retail-type property offerings being sold on headline performance or yield.

“As interest rates have increased, those funds are typically very highly geared and some of them have some very poor corporate governance practices,” he says.

“For example, they might revalue an asset by 5 per cent and then borrow against that revaluation to prop up distributions to keep the yields high — which is fraught with danger.”

These offerings look great in advertising literature, he says, when in fact “the portfolio on offer is of lesser quality assets, and they are highly geared”.

“As an investor, you don’t want a fund to be up to their maximum gearing when interest rates are in some cases higher than the yield on these assets.”

Burkitt has also identified that financial planners are “spending a lot more time than previously, trying to understand the alternative investment space, including unlisted property”.

“This is mainly because returns from a lot of asset classes, particularly equities, are going to be a lot lower this coming decade than in the last one,” he says.

“Absolute return type objectives are going to become commonplace among planners, and really, if you can get a 10 per cent total return per annum going forward you should be very happy.”

Along with the falling returns, he says, planners are also starting to recognise the importance of volatility within client portfolios.

“The volatility of LPTs, which have been stellar performers over the past seven or eight years, is about four times the volatility of unlisted property.”

For example, he says LPTs returned 18 per cent in the year to March, but with a volatility of plus or minus 9 per cent, as opposed to unlisted, which returned 10 per cent, but with a volatility of plus or minus 2 per cent.

Australian Direct Property Investment Association (ADPIA) director Owen Lennie believes there is “a bit of prevailing confusion between reliability and liquidity” in the unlisted sector.

“Property syndicates, the fixed-term vehicles, have always had a good reliability, although they obviously don’t have liquidity through the term,” Lennie says.

“However, as the SMSF [self-managed super] funds are generally growing, they don’t have a liquidity problem. In fact, their problem is very often they have so much money coming through the door they have to find somewhere to invest it.”

He adds that in providing a diversification for equities, the unlisted sector can have reduced liquidity without affecting consumer demand for the product.

“The more liquidity that can be generated the better, however, which I think is illustrated by the fact unlisted property funds are now growing much faster than the fixed term syndicates.”

In fact, he says syndicates “may well be fading away, Centro probably being alone now among the fund managers in producing very big syndicates, and as result is propping the market up”.

Key reasons for this are growing consumer demand for more product flexibility in the way of a withdrawal facility, and, secondly, the fixed marketing period for syndicates is a difficulty, he says.

Hybrid funds are “definitely growing in popularity, and, if you like, are the way of the future” for the direct sector, Lennie says.

One reason is they allow investors to “gain exposure to overseas property by investing in, say, Westfield, as an LPT, and also in a domestic real property portfolio”.

“The other advantage is the deep liquidity of those major LPTs provides an avenue for funding a withdrawal process (if indeed the fund provides this), while still getting a return overall for investors.”

In general, Lennie is confident that the growth of direct property investments will match the rapid growth of the SMSF sector.

“Whereas the major super funds are big investors in the LPT sector, SMSFs are big investors in the direct property sector.”

SMSF investors generally use direct property these days for two major reasons, he says, one of these being diversification from equities.

LPTs are correlated about 65 per cent with equities, he says, whereas direct property has pretty well a zero correlation with equities.

The other reason is to pay income into the SMSF, in order to pay “all the expenses” of the fund and potentially to provide pensions in the pension phase.

“If an SMSF trustee has an equities portfolio with a dividend yield of 3.5 per cent, for example, then they can ideally supplement this with direct property yield of over 8 per cent.”

The unlisted sector is yielding 9.5 per cent per annum on average overall, with “even the new ones paying an average of 8.5 per cent”.

A shortage of quality local stock is a big issue facing the sector, Lennie says, attributing this to a highly institutionalised property sector here, mainly the result of LPTs being an Australian invention.

“Somewhere between 40 and 50 per cent of property here, including the unlisted sector, is owned by institutional investors, whereas this figure is 12 per cent in the US and also in the UK.”

He says about 8 per cent of assets in the unlisted sector were offshore at the end of 2004-05, and expects that number has “grown substantially since then, and is likely to continue to do so, particularly in US and Europe”.

Large fund managers, such as an APM or Centro, are being encouraged to proceed offshore, he says, because the “number of available assets of any size here is a difficulty”.

“However, given that the overall economy is growing at the rate it is currently, there are new properties coming on line all the time”.

The shortage has also meant properties have “grown in value, even as sector yields have been falling, which has meant overall returns to the investor have been maintained”.

“The more competitive attitude of the banks to first mortgage lending has also helped to maintain returns in the face of rising interest rates.

“Of course, we are yet to see whether that can survive another rise in interest rates.”

Lennie says that while rationalisation will continue in the unlisted sector going forward, this will not be at the same pace this year as at recent levels.

“There were a fair number of M&As [mergers and acquisitions] last year, but I doubt it will keep going at that pace because the number of players in the sector has reduced.”

David Harker, director of boutique property group Fortia Funds Management says the growing focus on offshore exposure was one of many profound changes the sector is undergoing.

He believes the traditional unlisted lease model, without any development risk incorporated in it, will remain intact, but alongside a separate direct development model.

“The way the unlisted sector is set up, there is the ability to continue to create the standard unlisted lease model, but also the ability to create a separate development model.

“Therefore, the asset exposure and diversification can occur by choice at the adviser/client level, rather than co-mingling a whole lot of risk.”

Harker says there are some funds in the unlisted space that do co-mingle different sorts of asset class risk, and there is “definitely an appetite for that”.

“But I still think there is a strong appetite for the standard open-ended rental model, separate from the development model in unlisted property funds.”

Harker adds that the feedback he gets from financial planners is that the strength of the market demand for the standard model is “only going to continue”.

“The planners appear to want to diversify their property exposure away from LPTs into other forms of unlisted property that give them a surrogate to direct property.

“There is something of a reaction to the different risk profiles that are being co-mingled in LPTs, and the correlation that’s occurring between LPTs and the broader equities market.

“Obviously it’s sensible to have an exposure to all the asset classes, including LPTs, in a balanced diversified portfolio,” he acknowledges.

He said planners have effectively been “using LPTs as a quasi property exposure for their client portfolios”.

“However, now that the market risks have changed significantly, they are having to re-assess how that particular sector is performing in relation to the overall property equation.

“I believe that unlisted property rental model syndicates and open-ended syndicates are becoming more in favour from a general property exposure point of view.”

He acknowledges that a new hybrid investment model is emerging at the fringes of the unlisted property sector.

This model, which potentially incorporates some LPTs, some direct property and also some development exposure, “has a definite place” in the unlisted market.

“Some of our clients are suggesting that we should co-mingle some of those risks, albeit set to some benchmarks, and provide a one-stop shop in an unlisted property trust.

“That is, as long as we are covering the issues of liquidity, open-ended trusts and other typical issues they are concerned with.”

He also agrees that there is a dearth of properties available, because the market in the commercial sector has been so strong, but that this is opening up opportunities for the smaller players in the Australian space.

Fortia itself participates generally in the transactional space of between $15 and $70 million in end value per transaction, Harker says, which tends to be above the private investor level, but below the institutional level.

“The large players are obviously having to go offshore to find large-case assets, for the boutique players to come in and participate in the Australian space, which is, in effect, what’s happening on the ground.”

This is evidenced by an increase in boutique managers being established in the sector, in tandem with the increase in boutique equity fund managers, which has been ongoing for quite a while, he says.

“While there will always be a space for boutiques because it works off relationships”, he says, “there’s no denying the market is well-picked over in relation to quality assets in Australia, but that’s actually a worldwide western economy issue”.