Jersey unsure: Are the Masters mistaken?

Nobody doubts there are bargains in the US property market. But why is the biggest Australian venture yet launched – Dixon Advisory’s US Masters fund – buying low-grade stock in New Jersey?

PORTFOLIO POINT: There’s a good reason houses in Hudson County are cheap. Dixon Advisory – and Australian investors – should be buying elsewhere.

It was inevitable with the rush of activity in the US property market by Australian-based investors that sooner or later a major move would take place. Until now much of the activity has been piecemeal. Typically investors make their own way to the US and buy property (to read about Sue Shillabeer’s experience, click here).

But now the institutional fund managers are getting involved. Leading the way is the respected Dixon Advisory Group led by Darryl Dixon, Alan Dixon and the well-known financial journalist Max Walsh.

The Dixon US masters Residential Property Fund was launched with a $70 million IPO last June. More recently it raised another $26.9 million to further bolster its buying power.

On the heels of an intensive retail investor advertising campaign, the fund is now well on the way to raising the $140 million it is seeking. The fund listed at $1.60 in June, it is now trading around $1.62 on the National Stock Exchange.

This is the first Australian listed trust I know of to invest in US residential property since the subprime fiasco, so I have been watching it closely since it was announced earlier this year.

The fund’s aim is, to quote its product disclosure statement, “to target properties which have the potential to achieve superior risk-adjusted income and long-term capital appreciation”. The fund is targeting “the New York metropolitan area '¦ initially focusing on investment within Hudson County, New Jersey”. As of November, the fund had already spent $US32 million on 161 properties in this area.

There is clearly merit in buying at the bottom of the US residential property cycle. Given the economic pasting the US has experienced in recent years, it wouldn’t be difficult to identify prime real estate that is genuinely undervalued and could be expected to rebound strongly when the economy recovers. I’m thinking parts of Manhattan in New York, or the inner suburbs of Boston or San Francisco. But this is not what the fund has done.

Having visited New York several times and knowing it reasonably well, I was deeply alarmed to discover that of all the places they could choose, they have decided Hudson County, New Jersey, would be the focus of the fund, an area not exactly well known for prime real estate.

To begin with, marketing these properties as “New York metropolitan” properties when they are in New Jersey is not accurate. Americans refer to the “Tri-State,” the contiguous parts of New Jersey, Connecticut and New York that are commuting distance from Manhattan. Commuting distance, yes, but not within the New York metro area. As for the short commute, try driving it or being stuck on the subway during rush hour, especially if something goes wrong. It’s no 15-minute commute!

In mid-October, as part of my annual trip to New York, I decided to visit Hudson County to check whether my fears about the dangers of this offer were well founded. Unfortunately they were. Hudson County is doing it tough. There is little sense of resilience or prosperity and vacant houses are common. But this shouldn’t be a surprise to anyone as, according the US Bureau of Statistics, in April 2011 unemployment in Hudson County was 10.3%, compared to 8.7% nationally. This place is in a recession.

Worse, it is not merely a case that Hudson County is just going through a bad patch and that its long-term prospects are rosy. The streets of Hudson County contain highly variable, non-descript, and often unattractive architecture. This is something you don’t see in the PDS, which contains tightly cropped photographs of the fund’s properties, but without the extended streetscape. Any potential investor is well advised to use Google Maps to see the broader vista around these properties!

Unlike many genuinely undervalued precincts, Hudson County has not been gentrified, and the prospects of it happening in coming years are low. Gentrification occurs when there is a critical mass of incoming first-home buyers or upgraders, who identify strong future potential because a locale is underpinned by an intense and diverse array of services and infrastructure. They renovate the properties and their discretionary disposable incomes draw in boutique shops and restaurants.

This can turn a suburb from down-at-heel to trendy in a few years and drive strong capital growth in the immediate future. Unfortunately, Hudson County has few home owners: 70% of residents are renters compared to about 30% nationally. This is significant. It is owners rather than tenants that drive values, so you always want them in the majority. Instead Hudson County is an area of cheap, unattractive properties in a high unemployment context with a transient population of tenants and little in the way of amenity. Unfortunately, the fund confuses “cheap and nasty” with “opportunity”.

In its PDS, the fund’s proponents acknowledge that the area suffers from underlying oversupply, foreclosures, short sales and distressed sales. They also accept that there have been sharp declines in property prices, rents and sales volumes across the US and in this area in particular. At a minimum it contradicts the fund’s mission to invest in “properties which have the potential to achieve superior risk-adjusted income and long-term capital appreciation”.

The major selling points in the marketing literature are the low prices and “attractive” rental yields of these properties, especially in comparison to Australian properties. It cites properties priced at $US170,000 and with rental yields up to 12% of the property values. If investors believe that this is “attractive”, they are mistaken.

By going for high yield and low prices, the fund has chosen poor assets in highly compromised locations with no scarcity value. In addition, the PDS refers to multi-family dwellings; read houses that have been either designed or converted into apartments. This confers even less scarcity value.

Consequently, the prospects for sustained capital growth are severely limited and there is the high possibility of further capital loss because the recovery and bounce back will be slow compared to other parts of New York City. These properties are cheap because no one else wants to buy them and cheap does not equal a good investment. Why invest in something that the vast majority of the local population eschews?

What really takes the biscuit is the attempt in the PDS to suggest that an investment in struggling Hudson County bears any comparison to highly desirable Australian inner suburbs such as Kensington in Melbourne and Newtown in Sydney, where demand always outstrips supply and prices remain strong and yields sit at the optimal ratio to growth.

As I’ve noted earlier, I don’t have a specific issue with investors targeting New York property per se. It’s the fact that these choices are so compromised that worries me. A parcel of apartments in parts of Manhattan – say Tribeca or Murray Hill – would be far better at fulfilling the fund’s investment mission.

I’m afraid the fund’s proponents have demonstrated a worrying lack of understanding of what constitutes investment-grade property. This marriage of financial products and distressed property skills gives me concern that they are relying precisely on the kind of speculative principles – turning questionable assets into a tradeable security – that played a key role in the subprime problem in the first place.

Unfortunately, this ongoing zeal for financial engineering and lack of property knowledge has led Dixon Advisory and in turn many unsuspecting Australian retail investors to buy some very speculative assets.

Property Q&A

This week:

  • Positive vs negative cash flow.
  • I have to sell my beach house.
  • Melbourne with $400,000.
  • Should I buy off-the-plan in Canberra?

Positive cash flow

I would like your thoughts, regarding a strategy as advocated by Robert Kiyosaki (author of Rich Dad, Poor Dad), where he advocates the certainty of buying property to obtain a positive cash flow. This approach obviously would necessitate buying many such properties in order to create an excellent cash flow. Do such properties mostly have poor growth prospects, and in any case would this matter if you had enough of a cash flow to live off? Why, in your opinion, would I be better off to purchase (fewer) properties with high prospects of capital growth, but with a lower percentage rental yield over a 10-year time frame? How would the end results differ?

What a fabulous question. I categorically reject the positive cash flow approach as the way to secure your financial future. If you take the high percentage rental yielding, positive cash flow route you are – by extension – accepting low capital growth, because a property will either have high capital growth and a low percentage rental yield or a low capital growth and a high percentage rental yield.

Those who opt for a positive cash flow property might argue that this is a compromise they are willing to make, and that they are very happy to earn a strong income and forgo the capital growth. However, what they don’t realise is that they are also destined to earn less income than the capital growth property owner as time goes on. They will lose out both in terms of capital growth and in income.

This outcome is best illustrated by the following table. In this example there are two properties worth $400,000 when they are bought in year zero. Property A has 10% capital growth and a 5% rental yield. Property B, the positive cash flow property, has 5% capital growth and 10% rental yield.

As you can see from the table, not only is property A worth more than twice as much as property B after 20 years, but its rental income is also over 25% more at $135,550 a year compared to $106,132 for property B. This illustrates that it is capital growth that drives the increase in rental dollars. The percentage rental yield does not drive the return.

Beach house sale

I have reluctantly put on the market my fabulous absolutely beachfront house in Mission Beach, Queensland. A couple of years ago it was worth $1.4 million; I am asking $1.2 million but the local agents say I should be looking at $895,000. I get a good holiday rental return. I am only selling because of medical problems and will probably buy a two-bedroom unit in Melbourne. I think $895,000 is far too low, should I hold for two years?

I’m afraid your story is being heard in many parts of North Queensland, where there is an oversupply of prestige holiday homes. In light of your medical condition, this is an especially unfortunate situation to be in.

Given your belief that the property was worth $1.4 million in 2009, I recognise that it will be hard for you to make a dispassionate judgement about selling it for about $900,000 in today’s market. By all means, ask another agent or even a professional valuer to provide you a second opinion. Ultimately, we all have to deal with the current market as we find it.

It may well be the right decision to sell this property, particularly if you have built sufficient equity in the property to avoid crystallising a financial loss. The outlook for a well-chosen two-bedroom unit in an inner suburb of Melbourne is far more promising than for beach houses in North Queensland, where the economy is overly dependent on tourism and expensive beachfront property is a luxury rather than a necessity. Sadly, when conditions in the market or the wider economy are soft it is the luxury properties that are sold first. I do wish you well.

Melbourne on a budget

I’m looking to buy an investment unit in Melbourne. I’m planning on spending $400,000. Which areas would you recommend and what features should I be looking for?

With the softness of the Melbourne market over the past 18 months, entry-level investment-grade property has become more affordable and now sits around $400,000, so you are well placed. I recommend you consider a one-bedroom apartment in the inner southeast, such as Elwood and St Kilda, or the inner north/northwest, such as North Melbourne, Kensington and Flemington.

The ideal property will sit within a small apartment block of up to 20 apartments built between the 1930s and 1970s. It will be on a good street – not a main road – and feature consistent residential architecture. The apartment will be strata title, be in good condition, be at least 40 square metres, have a logical floor plan, possess a good outlook and not be compromised in terms of security. Be sure it has dedicated off-street parking.

Off-the-plan in Canberra

What do you think about the prospects of off-the-plan apartments in the Canberra and is the supposed glut of apartments in the nation’s capital really a worry?

I dislike off-the-plan apartments. They are invariably overpriced relative to the market rate, partly in order for the developer to make a sufficient profit. Buyers are too often mesmerised by the prospect of buying something shiny and new only to discover they have overpaid once they try to sell the property several years later.

Indeed, the market is likely to move against them more in the intervening years, as there are always more of these off-the-plan properties in the pipeline. Down the track all the owners compete with each other in the secondary resale market.

Canberra property has had a good run in recent years off the back of public sector expansion. Last week’s mini-budget suggests this period of fiscal expansion is over. Departments have been ordered to cap capital budgets and find a 4% efficiency dividend (cut) in current expenditure.

Given the Canberra economy’s dependency on the government sector, I would therefore counsel caution about investing in Canberra and certainly warn you away from the off-the-plan market.

Monique Sasson Wakelin is managing director of Wakelin Property Advisory, an independent firm specialising in acquiring residential property for investors. Monique can be found on Twitter @WakelinProperty.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Monique? Send an email to monique@eurekareport.com.au

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