Smart Investor portfolio report: property

Smart Investor portfolio supplement, August 2011

We’re all property investors one way or another. If we have a mortgage, we’re invested in real estate. But beyond our own home, there are several other ways of investing in property as part of a portfolio.

This article will focus on listed property – stocks that can be bought and sold like any other share, but which give exposure to real estate. There are two types of stock that do this: shares of companies that are engaged in property, and so-called A-REITs – Australian real estate investment trusts – which are a special type of investment vehicle that hold properties within them and pay out regular dividends based on the income that comes from those properties.

A-REITs have had a tough time in recent years. The financial crisis badly hit products like these, partly because of some bad habits that had crept into their management during the preceding good years: high gearing, ambitious dividend programmes, and a sense of being a bit too clever for their own good. Many A-REITs badly underperformed the Australian market through this period, and several got into real trouble.

For the first time in years, though, fund managers are talking with much greater confidence about the sector. “A-REITs are probably in the best financial shape they’ve been in for at least five, if not closer to 10 years,” says Stephen Hiscock of SG Hiscock & Co, a Melbourne-based specialist property fund manager. “If you go through all of the issues with the sector in recent years, they’ve been dealt with. Gearing is back to 2002 levels: it was far too high in the mid-2000s, well over 40% in many cases, but that’s been fixed. Banking covenants, in hindsight, were lax, but the vast majority of those have been renegotiated. Dividends had always been a concern to us: for many years, the average payout ratio was more than 100% of free cashflow.” That is, paying out more than they were getting in. “Now REITs are, for the first time in a long time, on a sustainable model, paying out on average about 77% of earnings. It’s a huge positive.”

And the general raison d’etre of REITs has returned to what it used to be: a stable, even boring model of paying out reliable and decent yield from incoming rents. “If you look at the management practices, there was a focus on non-rental income and poor quality earnings. Now there’s a renewed focus on going back to basics for the majority of REITs.”

Andrew McGrath, director of Reliance Investment Management, which is the manager behind a new property fund from Charter Hall, agrees. “We see the lessons learned in the GFC: back to basics,” he says. “They’ve got rid of non-core overseas property exposures, reduced their debt, and regained some of the safe haven benefits of property exposure. That’s reflected in their share price volatility, which is back to historical averages.”

And, on top of that, where once the sector was expensive, now it’s cheap. “Pre-GFC, the sector was trading probably more than 30% above fair value,” Hiscock says. “Now, on our numbers, it’s trading below fair value: in a technical sense, it’s a good time to get in.” The same applies to the valuation of the underlying properties, which have also fallen.

It all adds up to a positive outlook. “We are quite confident the sector will return more than 10% per annum:  a yield of 6%, with earnings growth of 2 to 4% over the next few years,” Hiscock says. McGrath adds: “The discounts to the net asset backing make it quite appealing. Normally we’d expect property returns to be in the 8 to 12% range. But since we see stocks trading back towards NTA [net tangible assets – that is, the value of the thing the REIT holds] in the long term, A-REITs should return to the higher end of that range, if not slightly above.”

Where should listed property fit into a portfolio? “I think listed property, ideally, should provide you with an inflation hedge with an attractive yield,” says Hiscock. “Over the long term, it will be connected to the direction of the commercial property market.” For this reason, comparing listed property exposure with investment properties is counterintuitive. “Residential has a very low yield on a net basis; if you deduct capital expenditure then net yield is very unattractive compared to REITs. In the REIT sector the net yield is 6.2%.”

And McGrath argues that listed property adds diversification. “Having your own exposure to residential property is one asset class; we believe commercial property is another.”

One of the oddities about listed property is that it tends to be very focused towards a few names, although not as severely as it once was. At one stage Westfield accounted for 53% of the listed property market in Australia; today it’s 27%, with Westfield Retail Trust adding a further 11% to bring Westfield’s overall stake in the market to 38%. This is a big issue for active managers, because if they significantly underweight Westfield they run the risk of looking foolish if they get it wrong (or smart if they get it right). Reliance, for example, has a total of 11% in the Westfield stocks. “We are index unaware,” McGrath says.”We believe in investing in stocks where there is true value, and we can find better opportunities relative to Westfield.”

Property trusts cover a range of different property sectors, from offices to warehouses, shopping malls to hotels. Fund managers tend to have different views on these sectors at different times. “We are more happy to be exposed to those sectors we call corporate, or commercial/industrial, than retail or residential,” McGrath says. He sees retail and residential as more consumer related sectors of real estate, “and we think the consumer is under a lot more pressure, whereas corporate Australia is basically benefiting from the flow down into ancillary services from the mining sector.”

Listed property is not the only way to go. Many mutual funds offer exposure to unlisted property – direct stakes in the bricks and mortar – or offer a combination of some listed and some unlisted property. The argument for unlisted property is that it represents much more of a diversifier than listed property, because when the stock market is moving around, listed property will tend to move in tandem with it, to an extent. The argument against it is that it is illiquid, and this became particularly important during the financial crisis. “For some investors liquidity is not a concern. They might have a long timeframe, and for them a modest amount in unlisted property is fine,” Hiscock says. “For other investors, for whom liquidity is important, REITs are the preferred entity in my view. But it depends on the investor.”

McGrath adds: “In the GFC we had a number of funds that were hybrid with exposure to listed and unlisted real estate, and when the tough times came, those funds had to close up redemptions and you couldn’t get your money out. Liquidity, for retail investors, is an important difference.”

And for those who do want listed property, there is an alternative to active managers: you can also get your exposure passively, through an index mutual fund or, increasingly, an exchanged-traded fund (ETF) which can be bought and sold like any other share. Vanguard, for example, has both a passive property fund and an ETF; State Street offers a property ETF.

“If investors decide they want access to property securities, they are really thinking about their overall asset allocation and about achieving diversification through holding a range of sectors in the portfolio,” says Robyn Laidlaw at Vanguard. “With a property securities index, they are getting diversified exposure to a range of Australian-listed property securities companies. You get retail, offices, industrial – all the different sectors of the property market.”

There are numerous other ways of getting property exposure: international property funds; in the near future, likely an international property ETF; and of course just buying a house as an investment property. But what’s striking at the moment is that after five years of bad news about listed property, there’s an uncommon sense of stability and optimism.