Wholesale funds give listed trusts a headache

In Colonial's case, the wholesale fund was its first in 10 years and like just about every other deal going on in Australian property, foreign investor appetite was strong.

These two important trends came out loud and strong in the latest 2012 annual research report by the research house PIR, which found that in the $279 billion listed and unlisted property trust sector, listed property trusts, or REITS, continue to represent half of sector assets under management - $139 billion, to put a figure on it - but unlisted wholesale funds rose to their highest ever proportion of the sector, roughly 29 per cent, to $82 billion.

At the smaller end of the spectrum, the various property securities funds and mortgage/debt funds continued to decline as a percentage of the sector.

The overwhelming conclusion is that while most REITs continue to trade at a discount to their net tangible assets (NTA), the shift in interest by big investors to unlisted wholesale funds will continue on the basis that the funds have greater flexibility in sourcing capital than their listed counterparts.

To put it into perspective, REITs and unlisted wholesale funds offer a high-single-digit yield, have acceptable gearing and their cap rates have not materially fallen since the global financial crisis. The big difference between them is that most listed funds trade at a discount to NTA and that makes it more difficult to fund a deal through new equity compared with recycling assets or borrowing money.

In contrast, the unlisted wholesale market doesn't have such constraints and has therefore been able to raise equity. The most notable examples include CPPIB, which recently committed to invest $1 billion in two office tower developments at Barangaroo in Sydney, with other wholesale investors committing a further $500 million.

Other examples include GPT Wholesale Shopping Centre Fund announcing a $100 million capital raising this month. The implication is that unlisted wholesale funds enjoy a lower cost of equity capital and greater flexibility in sourcing capital than their listed cousins, despite the latter spending the past 18 months buying back their shares.

It raises some interesting questions about REITs and whether they should be parking assets into wholesale funds rather than taking them on their balance sheet. It is a trend Westfield and GPT have started to embrace.

For the past 18 months Australian REITS have been focusing their attention on share buybacks to try to close the gap between their share price and NTA. The sector has spent close to $2 billion on buybacks and is expected to spend a further $2.5 billion in the current round of buybacks. REITS have spent an estimated $2 billion on acquisitions. compared with $16 billion for foreign investors in joint ventures, unlisted local funds, direct property or taking strategic positions.

Recent figures from CBRE highlight the sheer magnitude of this trend. In 2010, foreign investors accounted for 19.9 per cent of all deals larger than $5 million. At the time, CBRE noted this was "almost twice" their usual share of acquisitions. For the same year, REITs clocked in at 23.5 per cent.

Last year, foreign investors accounted for 30 per cent of all deals larger than $5 million, and 37 per cent of all deals larger than $20 million - the highest level in almost 20 years.

By comparison, local superannuation funds, wholesale funds and unlisted trusts accounted for a combined 21 per cent. For the March quarter of this year, foreign investors accounted for 27 per cent of deals above $5 million and 43 per cent of all deals above $20 million, which was far ahead of the 26 per cent of deals attributed to local wholesale funds and 20 per cent from local private investors.

It is a trend that is starting to worry some institutional investors, concerned that REITs are missing out on some of the best properties in capital cities.

Interestingly, REITs have outperformed the overall sharemarket over the past 12 months, with the ASX 300 REITs index up 4.86 per cent for the financial year, compared with an 11.07 per cent slump in the S&P/ASX 300 index over the same period.

It seems that the sector has well and truly bounced back since the global financial crisis, which dragged Australian investors in the listed and unlisted property sector to hell and back, with property values plummeting, debt levels ballooning, returns crashing and, in the case of listed property trusts, share prices falling up to 80 per cent.

PIR supports the view, with leverage now down to 26 per cent, and most categories of property well on the way to sorting out a massive mess of overengineering of their balance sheets, which got them into serious trouble with their banks.

"Deleveraged balance sheets, better capital management, and a focus on operational efficiencies (reducing vacancy rates and management expenses, while incrementally boosting income) all increase our confidence in the sector as a reasonably secure long-term investment," the report concludes.

A JPMorgan property analyst, Richard Jones, recently described the growth of the unlisted wholesale sector as explosive, partly benefiting from an inflow of foreign capital.

The trend is on, but if the gap between NTA and the share price of REITs continues to close, then it could further open up the sector.

As PIR says: "We live not only in a post-GFC world, but a world weighed down by a forthcoming demographic tide. Meeting these obligations will demand long-term returns in excess of the paltry yields on government debt."