Is there a place for direct property in investment portfolios?

With the financial crisis effectively over, Benjamin Levy examines the state of the direct property market and looks at the role it should play for investors in the future.

Property is meant to be a safe haven during a financial crisis, but elements of the property market were hit the same as other investment assets when the global financial crisis struck.

Now that property valuations have hit rock bottom, and with liquidity becoming a major concern for investors, questions are being raised about the role played by property in investment portfolios.

Liquidity concerns post-GFC

Liquidity has become a key concern for investors in the wake of the financial crisis. While direct property has been seen as a safe bet for many investors, the sector cannot provide the level of liquidity that other investment vehicles can, and investors may treat it inappropriately as a result.

Martin Hession, head of property at Australian Unity, says that investors need to be re-educated about the role direct property should play in their portfolios.

“Direct property by its very nature is illiquid. A lot of people have too much in direct property then start yelling and screaming when these funds close and can’t provide the liquidity they thought they were going to get.

"So the premise you should start with is that direct property is illiquid. If you need liquid assets, then you should be investing in something else, like cash.”

Most investors believe that when they invest in open-ended vehicles they can get their money out whenever they need it, but the GFC taught investors that this might not necessarily be the case, Hession says.

“Generally speaking it’s true, because in the good times there is more money going into the fund than there is going out of the fund, so that every day the people who want to get out are paid from the money of the people who want to get in.

"When there’s nobody coming in, and there’s only money going out, then that doesn’t work very well.”

The principal of Farrelly’s, Tim Farrelly, believes the managers of direct property are to blame for their investors treating the sector as more liquid than it was.

“The unlisted property trust managers haven’t done themselves any favours over the last two years. Rather than destroy their client’s capital, they effectively allowed their product to be misrepresented in terms of liquidity,” he says.

“People were told they could get in and out of these things and there might be an event which meant they couldn’t get their capital back straight away. And what’s happened in fact is that most of them have been frozen.

"The way they should have been represented is as fundamentally illiquid, but you might get liquidity from time to time,” Farrelly says.

There is an enormous amount of scepticism about unlisted property managers as a result, he says. The way direct property funds have been structured on the market is also a cause for concern, he adds.

“If you’re buying unlisted property, you are much better off buying it in an ungeared vehicle than in a geared vehicle. Now the guys running the unlisted funds have been used to running geared vehicles for so long they find this notion unthinkable,” Farrelly says.

In running a geared vehicle composed of 50 per cent borrowing and 50 per cent equity for a property exposure of 20 per cent, an investor would only need to use 10 per cent of their own money, Farrelly explains.

“But in doing so, what they’ve also done is borrow money inside that geared vehicle and paid a really big spread for it, and to compensate for that they’re having to hold heaps of cash outside the vehicle and are getting nowhere near the amount of reward on the extra cash than what they’re paying away to be geared inside the vehicle.

“Fundamentally, it just costs you more money and it increases the risks, and this is something people haven’t realised yet.”

However, Justine Hendry, senior wealth adviser at residential property and investment advice firm ProSolution Private Clients, says the amount of gearing in a portfolio is different for each client.

“Our average client would probably have $2 million to 3 million in total assets inclusive of property, a lot of that would be quite heavily geared,” she says.

“But it depends. You get young people who buy a property regularly and borrow up to 90 per cent, they might have three or four properties with only 20 per cent equity across the board, but older clients would have very little debt on their portfolio.”

Their clients’ cash buffers also differ based on circumstances, Hendry says.

Valuations and performance

At the height of the financial crisis there was an abundance of listed property groups that were going through savage revaluations of their portfolios, while the industry was divided about concerns that infrequent valuations were misrepresenting the value of unlisted assets.

In the middle of 2009, the Australian Prudential Regulation Authority demanded that super fund trustees increase the monitoring of their unlisted assets, including property, due to concerns that infrequent valuations misrepresented their assets.

Frontier Investments found the opposite, with a survey showing that out of 70 investment managers of illiquid assets, 65 were following reasonable valuation processes.

According to Mercer figures provided by Ken Prosser, head of property and infrastructure research at Lonsec, the unlisted commercial sector dropped 10 per cent in total returns during 2009. Prior years showed increases of between 5 per cent and 20 per cent annually.

However, valuations have bottomed out in the last 12 months and are beginning to edge up again, Prosser says.

“It’s one or two not so good years out of about a dozen, so it isn’t a bad performance,” he says.

However, the managing director of Perennial Real Estate Investments, Stephen Hayes, believes that while valuations have bottomed, both the listed and unlisted sectors will remain at low levels for some time.

“The valuations would be the same whether the building is owned by a listed property fund or an unlisted property fund — there hasn’t really been a distinction.

“Depending on which unlisted fund you’re talking about, if it’s some of the lower quality ones then the property valuations would have fallen more than the listed funds, where the quality of the real estate is very high.”

Whether long-term valuations of the property market will improve depends on a range of other factors, Hayes says.

“As economies improve and markets improve, sentiment improve, then real estate valuations might also improve. These assets are long duration assets, and they’re very cash flow stable assets,” he says.

Listed property trusts versus direct property

Despite the edging up of valuations since the markets bottomed in 2009, the industry remains divided on predictions for the future performance of listed property trusts (LPTs) and the direct property market.

For Farrelly, the problems in the listed property sector go to the core issue of poor quality management, and the capital raisings in the sector in 2009 are symptomatic of this.

“The people running the LPTs by and large managed one way or another to get through the GFC without having to sell too much in the way of property, largely by raising capital from unit-holders, which restored their gearing ratios,” he says.

“Now in the process of doing that, they’ve actually destroyed their unit-holders. The capital raisings have been done at such ruinous prices that it will be 25 years or more before LPTs get back to the levels of 2007, and the managers have taken a large measure of responsibility for that.”

As a result, investors in LPTs have become “extremely sceptical about the quality of management, particularly as the management that did all the damage is largely still in place,” he says.

Prosser, however, believes capital raisings will have the opposite effect on listed trusts and says there is still some prospect for growth in the listed market, but not when compared internationally.

“In comparison to their international counterparts, in the short term they will probably be held back a little bit because they had a number of equity raisings last year, [the effects of which have still] to wash through,” he says.

But when the capital raisings come through next year, it will lead to a return of earnings growth, Prosser says.

Hession believes there was an overreaction against LPTs during the financial crisis.

“LPTs had a lot of exposure to overseas assets, particularly in the US, and they actually owned the management companies which ran them,” Hession says.

“Most fund management models were marked down to zero, whatever value the market had put on the funds management part of the business was eradicated, and of course those companies with exposure to US assets were smashed.

“So the LPTs went way down beyond where they should have gone.”

However, the market has recovered extremely well from the low point of the financial crisis, he says.

Damian Fitzpatrick, fund manager for AMP Capital’s Core Property Fund, says quality direct property has bottomed in the last month and will show steady performance.

The drying up of lending in the market will also drive down the supply of direct property, forcing a return to more normal investment levels, he says.

“Because debt has been so hard to come by, banks won’t lend on anything that’s speculative, it has to be already 70 to 80 per cent pre-committed.

"That means that the supply of direct property that is coming on over the next few years is much more reduced, so we’ll return to more normal levels quicker than we would have perceived even 12 months ago,” he says.

However, Fitzpatrick warns that investors should be aware of the difference between quality direct property, such as well-located regional shopping centres, and neighbourhood shopping centres that would be hit by the disappearance of a single tenant.

What now?

Despite the recovery of LPTs, Hession says the listed property sector behaves too much like equities to give true exposure to the property market.

“Listed properties don’t really behave like properties, they behave like equities, so if the direct property market goes down 10 per cent, if equities go down 50 per cent, LPTs will go down 50 per cent as well, so they’re not a good proxy for property.

“If your financial adviser says you should have 35 per cent of your assets in equities, and 15 per cent in property, and that 15 per cent is in LPTs, then you now have 50 per cent in equities and zero in property.”

Hession believes investors should invest in direct property for exposure to the property market.

However, Hayes says the implied pricing in the listed market is much more attractive at the moment than direct property, while investors will also gain more liquidity.

“That’s not to say the direct property market won’t deliver reasonable returns at quite low risk; I think that will happen given real estate is cyclical, and real estate has come back. But saying that, you'll probably get a higher return if you invest in LPTs,” he says.

But investors should look to other assets for liquidity, according to Hession.

“These cycles are always going to come around every few years. If you're in retirement phase you have to work out how much it costs you to live per year, and have twice that amount in cash or highly liquid securities, so that when things deteriorate, you can live off your cash for two years and you don’t have to sell any securities.

“But the extent to which you can have a portion of your portfolio in illiquid assets, I would think anything up from 10 per cent to 15 per cent in direct property would be the upper limit,” he says.

Hendry counsels her clients that property should be held for a full market cycle of seven to 10 years, and often longer.

Only those properties that will deliver high capital growth are considered, Hendry says.

“The strategies are about long-term capital growth, that’s how clients make their money out of property, so it has to be 10 plus years. We don’t even like recommending to sell at that point. It’s a buy and hold strategy,” she says.

Population and demand, interest rates and residential property

It is clear that the residential market holds the edge over commercial property for the moment, but opinions are divided over which sector investors should move into.

While there is a growing population and continuing small supply in the residential market, interest rates will act as a counterweight to any large-scale price growth, according to Hayes.

“I think residential property will remain fairly benign in Australia. Australia is in quite an unusual position, in that the housing market has remained relatively defensive during the slowdown, and with interest rates rising like I said, I don’t expect too much in the way of price growth,” he says.

However, the slow action of the states to release public land for residential development may cause “very tedious growth”, Hayes says.

“There is a limited supply of housing, and we have got a growing population via immigration, so there are a few forces acting on real estate before interest rates impact affordability.”

Prosser also believes that demand and supply are two “pretty powerful” underlying forces in the residential housing market.

“There is still a gap between demand and supply, and that won’t change overnight unless the Government completely shuts down immigration,” he says.

“Balanced against that are interest rates. Once you get up to the 8 per cent level — when people are paying mortgages that starts to hurt a bit.”

Residential markets are getting “risky”, according to Prosser.

“You’d have to say residential would be, in the near term, probably getting towards the risky end if interest rates continue to move, and prices have bounced back pretty strongly in the past 12 months.”

Those residential property values have bounced back a little too sharply for his liking, Prosser says.

“So I’d say the commercial sector, which is pretty slow at the other end, those values haven’t moved up again since the GFC, so you’d probably be putting your money towards the commercial sector, rather than residential.”

Hession believes that the underlying fundamentals of a “huge undersupply” will continue to push prices higher in the residential property market.

“With no new supply for the next couple of years, there is going to be a bit of fierce competition for anything that comes on to the market, and that can only push values one way,” he says.

“If you have a look over the last couple of years, the residential market has outperformed direct property markets for sure because direct property values are still going down, whereas residential prices have been going through the roof, so over the last couple of years you would definitely have been better in residential.

“Once the competition for buying assets starts, which will probably be towards the end of this year or the first part of next year, then the combination of rental increases and competition for properties is going to push yields right down,” Hession adds.

Farrelly attributes the positive performance of residential property to the emergency interest rate cuts during the financial crisis last year.

“So far, the residential property market has pretty much sailed through the whole crisis.

"And a lot of that was on the back of the very big cuts to interest rates they made earlier; so people’s home loan rates came down dramatically, their ability to borrow probably went up marginally and, with the first home buyer’s grant, the Government put a floor under their property prices.”

However, the interest rates rises will have an impact later on, Farrelly says.

“As we go forward from here, my sense is as interest rates go up we’ll start to see some softening in the residential property market, but in the long run, I think we’ll get modest growth of around 3 per cent or 4 per cent a year from here on in, and that’s predicated on interest rates not going up a lot more than they are now.”

If interest rates go up any more than half to 1 per cent, the property market will come under a lot of pressure, Farrelly says.

Hendry, however, has priced any interest rate rises into her property models.

“We always use an average interest rate in all our modelling, so even when a lot of clients were on 4.8 per cent or 4.9 per cent interest, we always use an average rate in the low 7 per cent mark to make sure everything would work; and when we’re then looking at a portfolio from a risk point of view, we’ll usually add another couple of per cent on that to make sure it all works.”

Despite the impact the financial crisis had on the property market and the questions subsequently being raised about its future direction, investors’ enthusiasm for property has not dimmed.

“We were still running a waiting list through the GFC for new business clients that wanted to come and join us, so we had an abundance of clients through that time,” Hendry says.