The lure of unlisted property trusts

Unlisted property trust returns have produced good returns … but know what you’re getting into.

Summary: From property syndicates to open-ended trusts, investors have an array of choices when it comes to investing in property without having to buy the whole shop, or shares in a listed real estate trust. And average returns have been good over recent years, with industry data showing investors yielded 8.2% per annum over the past three years. But there are drawbacks to some unlisted property structures, and investors should tread carefully.
Key take-out: For investors averse to the illiquid nature of property syndicates, continuously open-ended property trusts don’t pose as much risk as they don’t have a maturity date or limited number of units, and investors can retrieve their capital at regular periods.

Key beneficiaries: General investors. Category: Property.

Unlisted retail property funds are yielding around 8% according to the latest data, yet investors remain coy about investing in the sector despite their appetite for real estate.

The advantages of the industry are clear:

  • They enable investors, who don’t have enough capital to directly invest in commercial property themselves, to pool their funds together with like-minded investors to buy a property together.
  • They also offer pure exposure to property, without the sharemarket volatility that has rocked Australian real estate investment trusts (A-REITs) in the past.
  • And, as Max Newnham highlighted last week in Getting to know unlisted property trusts, unlisted property trusts have a high percentage of non-taxable income because of depreciation deductions and the writing off the capital cost of the building.

Unlisted property fund types

Generally, unlisted property funds take three forms: syndicates, continuously open-ended trusts and those that offer investors the opportunity to redeem their investments periodically.

Syndicates generally reward investors with higher returns, but they also pose the greatest risk as they are illiquid investments.

Investors pool their money into the syndicate, which is a close-ended fund that usually consists of just one property, for a specified time – generally between five to seven years. When the maturity date is reached, the members vote on selling the property, whereby the trust is wound up and they are paid out (hopefully at a capital gain).

Ken Atchison, from Atchison Consulting, warns investors that they need to be willing to part with their capital for the specified time, as it can be extremely difficult to retrieve it early, unless they find someone willing to buy their units off them.

There are currently syndicates where investors pool their money into development, only realising a gain at maturity when the property is sold, and also syndicates which offer annual returns.

For investors averse to the illiquid nature of syndicates, continuously open-ended property trusts don’t pose as much risk as they don’t have a maturity date or limited number of units, and investors can retrieve their capital at regular periods.

According to Anthony De Francesco, executive director of IPD, a global provider of real estate performance research, unlisted property funds are currently split about evenly between open-ended trusts and syndicates in terms of gross assets under management.

However, De Francesco and Atchison agree that syndicates are increasingly the most popular structures investors choose.

Choosing the right unlisted property fund

Retail funds are predominantly focused in the secondary market, unlike wholesale funds, which can pool enough capital to buy primary market properties. Investors need to be wary about several potential pitfalls, though good opportunities do still exist.

Despite undergoing deleveraging, De Francesco and Atchison say unlisted property funds are still highly leveraged investments. The average unlisted property fund is geared at 47% (it was over 60% pre-GFC).

“Is that income yield really supported by core, quality-type assets, or is it bumped up by gearing?” De Francesco asks.

Atchison says around the 40% level is tolerable in today’s interest rate environment, and investors should stay away from funds that negatively gear, as it means they have a cash flow problem.

Another important consideration is the fund’s fee structure. There can be multiple fees, including those relating to acquisitions, disposals, financing, liquidity and management.

“Management fees are fine, but the rest I have problems with,” Atchison says.

Atchison also advises investors to select properties with long lease terms to provide a consistent return, and to check the PDS to determine the quality of the building to avoid significant capital expenditure.

“The most significant thing in terms of quality is your rental income stream,” Atchison says. “If you’ve got Commonwealth Bank as a tenant for another 10-15 years you will spend the money to make sure they are still there.”

As with any commercial property, De Francesco says investors need to understand property exposure by sector and by geography. Their performance can be widely different depending on the underlying drivers in the property market at the relevant time.

Unlisted property trust performance

Performance results released last Thursday by IPD and the Property Council of Australia, displayed in the chart and table below, show unlisted property funds have delivered a total return of 7.5% over the past 12 months. Their three-year average is an even more impressive 8.2%.

Syndicates – which are becoming increasingly popular – have dominated the sector, making a total return of 12.6% over the period.

In comparison, the median total return of Australian real-estate investment trusts (AREITs) have returned 6.4% over the past year. While shares in Westpac, Commonwealth Bank, National Australia Bank and ANZ have averaged a total return around 14%, their capital growth looks unlikely going forward.

It must be said that capital growth for unlisted retail property trusts has been negligible. This is because capitalisation rates for secondary properties (which the trusts buy) haven’t firmed. The cap rate, which is the net income of a property divided by its value, reflects the return investors are prepared to accept at a specific time.

Instead, cap rates have been firming for primary properties where the market is seeing more demand, and where wholesale unlisted property trusts usually invest.

While information about how each of the unlisted property trusts perform is scant, IPD and the Property Council of Australia can display the top 10 performing retail unlisted property funds over a one and three-year period, shown below.

Syndicator Sentinel Property Group takes the top four spots on the tables for both periods. In the three-year period, other strong performers are Mair Group, Cromwell and Arena Investment Management.

Yet fund flows in unlisted property funds remain in negative territory in the year to March 30, according to IPD.

With memories of the well-publicised debacles of unlisted property funds during the GFC, investors are more reluctant to engage in investments they aren’t as familiar with, and are more selective when they do, says De Francesco.

De Francesco says capital flows had been improving through 2012 and 2013 as the industry underwent deleveraging, but that appears to have slowed in 2014. Further, he says a number of projects have reached maturity and are being wound up.

De Francesco believes capital flows will improve in the next 12 months when that capital is recycled back into new projects, but demand from new entrants – what would be the driving force for the industry – remains tepid.

A number of unlisted property trusts, held within Centro and Gold Coast-based Octaviar, were caught by the credit squeeze during the GFC. Thousands of unit holders were forced to choose between selling assets, floats and raising capital.

On the other hand, Atchison says the appetite for unlisted property funds is there, but the avenues with which to access them have become more restrictive.

“In the superannuation space liquidity has become a major feature for APRA (the Australian Prudential Regulation Authority) post-GFC, and they have put major constraints on platform operators permitting unlisted property funds,” Atchison says.

Unfortunately mFund, a much-publicised service launched by the ASX, doesn’t cover unlisted property funds – at least for now. The service is designed to provide retail investors – particularly SMSFs – with an easier way to access unlisted managed funds across a variety of asset classes, but initial requirements from the Australian Investment Insurance Commission (ASIC) stipulate only simple managed investment schemes can be made available.

To access unlisted retail property funds, Atchison says investors now must contact them directly. Some managed superannuation fund structures are also restricted in accessing them, he says.

Atchison believes the supply of further unlisted property trusts is constrained by competitive pressures across the property market in general, particularly from overseas investors.

“Back in the hey-day of syndicates, they had excellent pools of good-quality assets,” he says. “There’s just not the same opportunity today.”

However, despite the sector’s mixed history and the same specific dangers, it’s undeniable that the lure of 8% returns per annum will attract a new generation of investors.

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