Tipping point The double-digit growth in unlisted real estate funds thanks to cheap money could be coming to an end, particularly for newer releases, writes Duncan Hughes.
Unlisted property funds have blitzed other asset classes to generate returns of more than 20 per cent over one and five years by using record low interest rates to invest in retail, commercial and industrial properties.
But some analysts are concerned that accelerating performance with high levels of gearing could create problems for recently launched funds, with tight lending conditions if interest rates begin to rapidly rise.
Unlisted property funds generated returns of almost 22 per cent in the year ended December 31 (the most recent analysis) compared to about 20 per cent for real estate investment trusts (REITs) investing in local property listed on the Australian Stock Exchange and about 18 per cent for shares.
“The period of turbo-charged growth fuelled by cheap money will end as interest rates rise,” warns Dugald Higgins, head of responsible investment and real assets at Zenith Investment Partners.
Kevin Prosser, research manager of direct assets at Lonsec, an investment and ratings group, says overall gearing is “reasonable” at 40 per cent to 45 per cent of assets under management.
A high gearing ratio means a trust has a larger proportion of debt compared to equity. A low gearing ratio means the trust has a small proportion of debt versus equity.
Prosser says managers are aware of the potential impact and many have hedged against the risk for up to three years, fixed rates with their lenders or are reviewing potentially vulnerable variable costs.
Potential problems are likely to come from recently launched funds involved in construction projects that might not have hedged their borrowing and are facing rising costs, or disruptions, because of shortages in the building sector, say analysts.
There are estimated to be about 600 unlisted property funds with assets totalling about $20 billion, says Zenith’s Dan Cave, a senior investment analyst.
At least 30 funds are estimated to have been launched in the past 18 months with assets totalling about $3 billion. These include about 12 office funds, five retail and four industrial funds with the remainder a mixture of sectors.
Listed property trusts and unlisted funds are similar to the extent that investors contribute capital for a share of the assets either in shares (for listed) or units (unlisted).
Investors receive income (called distributions) and, if asset values increase, a capital gain on their original investment from either the rising share price (for listed) or the sale of the asset (for unlisted).
Listed funds typically yield 3-6 per cent and unlisted about 6-8 per cent. The premium is because there is little or no liquidity.
Property Funds Association analysis shows that unlisted funds rebounded from the pandemic, helped by low rates, economic growth and a recovery in corporate earnings.
Performance was underpinned by buoyant rental income that was boosted by recovering rental incomes for assets that had been affected by the COVID-19 lockdown.
Surging property prices for industrial and logistical property, particularly warehouses, more than doubled total returns to about 30 per cent.
Prime industrial rents are expected to increase about 11 per cent this year (more than double the growth in 2021) and to keep rising at double-digit rates over the next three years as the e-commerce boom drives up demand for warehouse space, analysis by CBRE and JLL shows.
Total returns for offices nearly doubled to more than 9 per cent as employees returned to work as lockdowns eased.
Retail, which slumped by more than 10 per cent in the pandemic, bounced back to post 6 per cent growth.
Strong price growth means capitalisation rates (a key measure for investors calculated by dividing net operating income by property value) are at historic lows for most markets.
Investment adviser Alex Jamieson, founder of AJ Financial Planning, says investors need to consider the impact of rising interest rates, particularly for aggressively geared funds involved in building projects under pressure from sharply rising costs.
Interest rate increases are likely to be rolled out over the next year or two and for many funds the impact could be offset by earnings recovery as the economy strengthens, according to analysts.
For example, higher wages might be inflationary but could boost demand for retail assets as retail spending among low and middle income earners increases.
But Zenith’s Higgins says: “There are many funds we feel that are high-risk propositions when considering that we are probably coming out of a high-growth environment and entering a period where the easy gains from rising markets will be harder to come by.”
Higgins believes many smaller operators are underestimating the challenges and costs involved in achieving the higher benchmarks for sustainability required by tenants and potential future buyers.
“We are essentially at a point where any company or fund that cannot demonstrate deep environmental, social and governance credentials, which naturally spans a wide range of sustainability and social issues, will simply be ‘uninvestable’ to institutional investors,” he says.
“We know from experience that many businesses with less in the way of resources to devote to these disciplines are increasingly at greater risk of being stranded by capital markets that are demanding greater transparency on how these issues are addressed.
“These views are likely to increasingly flow down to retail investors as scrutiny on these.
