The Outlook for Unlisted REITS in Australia

By Jim Papanicolaou

As the first positive signs of economic recovery begin to appear in the form of an improvement in share market performance, improved retail sales and stronger residential property clearance rates, many analysts are now questioning whether such data represents a short term response to the Federal Government stimulus package or the first meaningful signs of a truly sustainable economic recovery.

Analysts and investors alike are also turning to the question of what this means for unlisted REITS and the property sector in general going forward.

All property investors have suffered during the downturn associated with the global financial crisis. Unlisted REITS have not been immune from this downturn, however a recently commissioned report for the Australian Direct Property Investment Association (ADPIA) prepared by Atchison Consultants has found that direct property investments suffered less than listed trust holdings.

While listed property trust returns outperformed unlisted property trusts from June 1989 to June 2007, the situation was reversed from July 2007 as the market collapsed. Measures of volatility and downside risk show that unlisted property trusts held up better than investments in listed property trusts. Hence the inclusion of unlisted property trusts in diversified investment portfolios could reduce the chances of negative returns. This augurs well for unlisted property trusts going forward as the value of equity portfolios continue to recover and as managers look to diversify and rebalance their portfolios.   

There are, however, still a number of challenges facing property trusts. High levels of gearing and an inability to refinance due to lack of available finance from traditional banking sources has been the most challenging issue for the property industry over the past 12 months and still persists to date. Any new funds face similar lending challenges unless they can show very high levels of pre commitment (usually over 75%) from either property sales or tenancies.

This coupled with moderating demand for office, commercial and industrial space over the last 18 months have resulted in lower property valuations across Australia and continues to hold back any signs of early recovery in the property sector. This is expected to be the case until demand for business investment picks up off the back of sustained signs of recovery in economic activity.

Unlisted property trusts are however well placed to benefit from current market fundamentals that have seen a lack of competition for properties from institutional investors still looking to improve their balance sheet positions.

The fundamentals for future property investment also remain sound. These include projected levels of future population growth and long term growth prospects for the Australian economy in the South East Asian region off the back of demand for resources and general trade activity as the global economies recover. This combined with current levels of interest rates and a softening of capitalisation rates over recent times (leading to higher yields on property investments) do present some attractive investment opportunities at the present time.

Not so long ago, the combination of high capitalisation rates (leading to lower property yields) combined with high interest rates resulted in many property product providers seeking to satisfy the demand for higher income yields by including excessively high levels of gearing (usually 55-70%) and relying on complex structures feeding capital, complex development and hedging gains rather than pure rental returns. This was unsustainable.

In response to the current circumstances unlisted property product providers are now responding with a more ”back to basics” approach toward product offerings which capitalise on the higher available yields and lower interest costs at present to offer a more stable product based on the pure rental returns.  Much lower gearing ratios (of between 40-55%) are now also being adopted.

The lessons from the economic downturn, the fallout from the recent failures in the industry and regulators response to these is also shaping unlisted REIT product offerings going forward. There is a move away from large upfront and trailing commission products as advisers turn to fee for service models. Fund managers are also reducing levels of management fees to remain competitive. The combination of these changes and good investment opportunities should result in positive benefits for investors going forward.

Jim Papanicolaou is the General Manager with Kinsmen Securities Limited.

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