Top fund managers: Cromwell Funds Management

The property sector is trading at a premium to book value, but there is still some upside to be found.

Summary: Fund manager Stuart Cartledge's Cromwell Phoenix Property Securities Fund has had a stellar performance in recent years, making the most of some very undervalued stocks. But as rates shift, future returns are difficult to forecast with any great precision. The team has recently opened a Core Fund that gives investors access to the same management team.

Key take-out: Property is likely to underperform broader equities in a rising interest rate environment.

Key beneficiaries: General Investors. Category: Property Investment. 

Stuart Cartledge is the managing director of Phoenix Portfolios, which implements the investment strategy for Cromwell Funds Management’s listed property funds - the Cromwell Phoenix Core Listed Property Fund (Core Fund) and the Cromwell Phoenix Property Securities Fund.

In March 2015, his team launched the Core Fund to provide investors a traditional benchmark aware fund.

With less than six months of performance data the Core Fund is still very new. But as a comparison, Stuart’s results in the benchmark unaware Cromwell Phoenix Property Securities Fund - which has the same management team and research functionality - are noteworthy. It has returned 21 per cent annualised for five years, nearly seven per cent above its benchmark.

While this hugely successful fund is now closed to new investors, there is an enormous amount of overlap between it and the new Core Fund, Stuart says. The Core Fund is still able to have five per cent positions in non-benchmark stocks. And the team is aiming to beat its benchmark, the S&P/ASX 200 A-REIT Index.

In our interview, Stuart gives us his astute insights into the property sector, focusing on yield, what to expect from the asset class (low growth, inflation protection) and lower debt levels.

Stuart Cartledge, Portfolio Manager, Cromwell Phoenix Property Securities Fund.

Source: Cromwell Funds Management

DD: How will a rise in interest rates affect the property sector?

SC: A lowering of interest rates, which is really what we’ve seen over the last 10 years, has sort of a double benefit. Firstly, the property stocks themselves have a lower interest bill because in pretty much all cases they’ve got a reasonable amount of debt or part of their capital structure is debt, so as they roll over that debt, they are issuing or borrowing at lower interest rates.

The second thing that’s happening is as bond rates come down, investors use the bond rate as part of the calculation to come up with a discount rate and ultimately if you’re using a lower discount rate, that enhances the value of securities. So lower interest rates are good for all types of securities, but property particularly is seen as a fairly interest rate sensitive sector and that has been a driver of strength in the sector over the last three to five years.

So when they rise you do expect some of those benefits to disappear?

Yes, the tailwind becomes the headwind. And, that would be my argument across pretty much every asset class. Property, I think, has been seen as a more interest rate sensitive sector. At some point interest rates are going to move upwards, but if you make the argument that we’re in a rising interest rate environment because we’ve got a strong economy, then every asset class is going to be taking some kind of headwind.

But obviously on the other side of that, they’re typically going to be earning more, whether that’s in a property trust sense or whether that’s through rising rent - because as the economy improves, you’re typically going to see some movement in rent.

So everything might start moving up in a world of rising interest rates because we’ve got a stronger economy, even though you’re discounting everything back at a higher discount rate. So there are two effects there, but I think there’s a positive effect on the top line in terms of stronger earnings potential for the non-property sector and therefore, I would argue, property is likely to underperform broader equities in a rising interest rate environment.

What have been the main drivers of the outperformance in your Property Securities Fund?

It’s been an extraordinary period. Just to expect seven per cent outperformance under normal conditions I think would be a tad optimistic. So in that period we’ve seen the recovery from the GFC, the meltdown that occurred to property during the GFC period and a lot of property stocks were very, very oversold.

There were some very good opportunities for active management through the last five to seven years and we’ve benefited from that. So, simplistically it’s good stock selection, but there were some outstanding opportunities to buy some very oversold stocks that were unloved and people just didn’t want to be there at any price. And I guess we’re fairly mechanical about the way we look at things.

We try not to fall in love with stocks or hate them. The key metric for us is our valuation versus price and where we have had some big wins is in stocks that people have just I guess thrown the baby out with the bathwater and we’ve chosen to take a position in them. And some of those have paid off very, very strongly.

Over the past year you’ve given up a significant amount of outperformance. Should investors be worried?

The property sector is absolutely still the beneficiary of lots of capital chasing assets that will generate a reasonable yield. And we’ve certainly seen this particularly in the office market where in particular you’ve had foreign buyers that are looking at seeing opportunities and seem to be comfortable to buy assets on five per cent and six per cent type yield. And that’s not at the moment reflected in the book value of most of the securities that we look at in the REIT space, so there is still valuation upside to the book value.

So while the sector is trading at a premium to book value, I would argue there’s a fair bit of upside pressure on those book values and the market perhaps is anticipating some of that but not all of that.

So what do you think future returns for the sector are going to be like?

That’s again a very hard one to give you a lot of clarity on. I guess we think about it over the sort of medium to long term rather than look at the sector and say, well, it’s currently yielding something of the order of five… five-ish per cent in terms of the distribution. Underlying earnings yield is a little better than that. Earnings yield is probably more in the sixes anyway. And on top of that you’re going to see some type of growth. Now, property is not a high growth sector typically, but you should expect at least to see some kind of inflation type growth levels. If you put sort of a six per cent earnings yield and add two and a half per cent inflation, you’re up to eight and a half per cent. That’s probably not an unrealistic expectation over the medium term from where we’re at today. But it could be anything between, you know, between minus five and plus 10 per cent over the next 12 months or easily outside of that range. It’s so hard to tell. But over a five year view I would say eight and a half per cent would be not unreasonable.

After the GFC are you conscious of how much debt the trusts you invest in have?

I think that’s something as an entire market we’re all far more conscious of. I think the key to it is to be honest. Yes, we’ve now got a sector that’s got a lot lower leverage than it had back in the GFC days, so even in the event of a GFC mark II, the impact to valuation is going to be massively less than it was before.

But I think the other lesson that we learned out of the GFC is that debt has maturity dates on it, and debt matures, and at some point you need to refinance that debt. So we’re far more conscious today of looking at the debt profile of a trust and, in the perfect world, making sure that it’s nicely spread out over the forthcoming years rather than having one or two big lumps of maturity they may struggle to refinance.


Daniella D’Ambrosio is a writer at brightday