Getting a great price on a building is one thing, re-investing the money is another matter entirely. Re-investing in a new property, in this market, results in diluted yields, or does it? Should listed funds be sitting on money made from sales? Investing in each other? Or doing something completely different? Will this dynamic be instrumental in furthering the consolidation of the listed property sector?
 

John Rainier

Managing Director Allan Gray Property Trust

There are essentially four things that a seller of property can do with the proceeds. The relative attractiveness of each often depends on the stage of the economic cycle.

Buying replacement assets is obviously one, but it is currently difficult to find property with the required growth prospects in a low inflation environment to justify the prices often asked.

Paying off debt could well be attractive and give enhanced returns for unitholders until conditions change and increased debt again becomes attractive.

In 1970 George Akerlof published his work on “The Market for Lemons”, highlighting the concept of adverse selection which has to do with hidden characteristics of products due to information asymmetry.

This is so true in the direct property market where the seller always knows more than the buyer and so supports the case of reinvesting proceeds from sales in improving buildings already owned, correcting the flaws already identified and understood.

In addition, the land is generally already paid for enabling higher initial yields than would otherwise be possible, as well as improving the earnings growth prospects of the “old” as well as new investment.

This principle is even more true in the current environment of low interest rates which has driven property prices, both listed and direct, to new highs and made the fourth alternative of share buy-backs unattractive, unlike the days when listed property funds were trading at a discount to net asset value.

Sensible portfolio management is always about enhancing the total rate of return – that is initial yield plus income growth – of a portfolio. Selling properties with poor prospects and reinvesting these in the existing portfolio when income growth can be enhanced is sensible.

Andre Stadler

Managing Director Catalyst Securities

The current real estate market is overwhelmed by an unprecedented level of liquidity. What was once one of the key impediments to being taken seriously as an asset class has become a key dilemma for most listed property fund managers.

Access to capital through sale, raising new equity or debt funding is no longer the challenge; matching that capital against a sufficiently value-adding opportunity is.

In order to create perspective on the dilemma we need to create a broad framework – the historic rolled yield on the listed sector is approximately 8%, which is low and on par with the 10 year bond yield, despite the higher risk status of the sector. This is due to an expectation for relatively high income growth of between 5% and 7% per annum over the next five years.

Investor income return demands are attractively low but total return expectations have not changed that significantly – investors are expecting and demanding growth.

Fund managers need to assess opportunities relative to their investor expectations, which are in part a function of how the fund is positioned to the market – strategic core, market neutral, value add or opportunistic. The current sector proxy is a forward yield of 8.6% and your opportunity set develops from here.

For an unleveraged fund, selling an asset on a forward yield above this level is dilutionary on equity income growth unless the capital is immediately applied to a new opportunity with a similar initial yield, but better long-term growth prospects.

Any capital allocated to cash is significantly dilutionary for the period it remains in cash.

For a leveraged fund the capital can be applied to floating rate borrowings as an interim measure and will not be dilutionary as long as the sale forward yield is below 9%. Proceeds from sale yields above this level could be applied to reduce expensive fixed rate borrowings, which for certain funds are in excess of 11%.

These strategies would provide a temporary solution to the initial forward yield implication of a sale, but not the longer-term growth expectations from investors.

De-leveraging will reduce the equity income growth rate in future years, certain investors will be appealed by the lower risk and accept lower growth, but this trade off needs to be carefully managed relative to investor expectations.

The evaluation process of acquisition and sales together with the funding mechanism cannot be based on initial yield implications alone – increasingly cognisance has to be given to income growth together with portfolio and capital structure risk implications and the resultant impact on equity cost of capital.

Mike Flax

CEO Spearhead Property Holdings

Reinvestment risk is one of the great risks facing the listed property industry at the moment.

By divesting from an asset that provides a certain return ahead of the company’s weighted cost of capital, the company puts its earnings at risk if the next best option for reinvestment is into its bond at a lower return (bond rates are currently about 8.5%) or into another property asset at a lower yield.

Often there is a severe lag in acquiring replacement assets or sometimes there is a complete dearth of replacement property assets. The market is awash with stories at the moment of too many buyers chasing too few commercial property assets. This “virtuous” cycle has a bad habit of driving capitalisation rates down to levels approaching the company’s average cost of capital.

Besides the real risk of reinvesting at a lower yield are the concomitant costs of dealing in property: Capital Gains Tax, legal fees, bond raising fees, stamp duties, and the big one: agents’ commissions!

But certainly obtaining a similar yield to that of the property sold is often very difficult as well. A company strives at all times to upgrade its portfolio and this often means having to buy in at a lower yield. New generally translates into “low yield”.

As far as investing in other listed companies is concerned, I believe that investors (especially discerning institutional investors) are looking for specialist property funds. They don’t necessarily want generalists, and hybrids are just that – generalists!

They want to see the specific specialist fund beating the market by being better than the pack through their specialist focus and knowledge.

So no, consolidation will not happen with the advent of the “specialists era”. There will be more, smaller, focused funds, outperforming each other and being able to do that by being nimble and quick.

Wolf Cesman

Madison Property Fund Managers

Every fund wants to grow in size, which is achieved through the acquisition of quality assets and which in turn creates less risk and greater liquidity. Part of this process involves selling and culling. If you are holding assets that do not match your investment strategy, now is the time to sell in a market where there is huge competition for property assets. Use the sale proceeds to reduce debt.

Ultimately there are two types of buyers: investors and traders. Regardless of the prevailing market forces a trader will sell an asset for a profit. The investor however will have a longer-term view and not be coloured by short-term gain. Asset management gives preference to the longer-term view. However, this does not preclude selling. Properties should be constantly evaluated on at least a three-year projection. While a property may be performing well today, its longer-term outlook may not be ideal for retention in a portfolio. The solution is to sell whilst value can still be obtained from the property.

Publisher: Madison Property Fund Managers Property Innovation
Source: Madison Property Fund Managers Property Innovation