SMSFundamentals | Apr 05 2013
SMSFundamentals is an ongoing feature series dedicated to providing SMSFs (smurfs) with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
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This article was first published exclusively for FNArena subscribers on March 21 and is now open for general readership.
By Greg Peel
[Note: Unless otherwise stated, all tables are courtesy of Charter Hall Research]
Asset Class Performance
When assessing the performance of asset classes for longer term investment, comparisons will invariably use a stock index as the proxy for "equities". In the case of Australian equities, the benchmark is usually the ASX 200, and to be meaningful the accumulated index (including dividend yield) is used. While there is no real alternative to using such a benchmark as the proxy, few longer term investors will actually hold "the ASX 200" but rather will hold some individually selected portfolio of stocks. The ASX 200 is heavily weighted to only seven of two hundred stocks — two big diversified miners, four big banks, and one big telco. If an investor does not hold a weighting of all these seven stocks in their own portfolio, immediately the ASX 200 index becomes a poor proxy for "equities" performance.
This is very much the case at present. The most recent leg of the wobbly four-year rally off GFC lows has been driven by solid yield-paying stocks, such as the aforementioned banks and telco, while the big miners have well and truly been left behind. Holding the right stocks in your portfolio over this period would have thus provided a much better "equity" performance than the ASX 200, and considerably better than holding the wrong stocks. We could go further and suggest a portfolio that over the right period of time has held all of the "right" stocks in weightings greater than the ASX 200 (such as some of the more spectacular mining services stocks, or the online classified stocks for example) then as a SMSF you'd already be thumbing through brochures for luxury yachts.
Such a performance would no doubt have involved a fair bit of portfolio management, and not so much "set and forget". Not all SMSFs whish to be, or feel experienced enough to be, so active an investor. The great number are content to hold a passive "balanced" portfolio on the assumption that, over time, diversification will provide a solid risk/reward balance, and on the assumption that there's better things in life to do in employment/retirement than watch the stock markets all day. On that basis, the ASX 200 is still the best proxy to use for “equity” performance comparison.
Having said that, now observe this rather interesting table:
Here we see an x-axis of 15-year compound return for various asset classes, and a y-axis of the long term volatility of those returns. Return is obviously important, but volatility of return is also very important. Consider, for example, that your stock portfolio held all the 30 Dow Jones Industrial Average stocks in 2007 and still does in 2013. Ignoring a couple of constituent changes in that time, your net result over the period is flat (plus dividends) given the Dow is now back at its 2007 highs. Not a bad result for a GFC. But if you’d sold in late 2008 in panic, and were looking to perhaps buy back in 2013? Volatility of returns is very important with regards to investor psychology. It is also fundamental when one considers that an elder brother who reached retirement and cashed in his super in late 2006, and a brother two-years younger who did the same in 2008, would now be the Prince and the Pauper.
There are ostensibly four asset classes marked on the above table, although for reasons which will become clearer later, the table highlights industrial property as a subset of general Australian property. The other three are Australian government bonds, listed Australian real estate investment trusts (A-REITs), and “equities”, as benchmarked by the ASX 200. The higher up the x-axis the greater the compound return on that asset over 15 years. The further right on the y-axis the greater the volatility of those returns. With a dive of 50% from 2007-09 and a subsequent partial rebound, the ASX 200 is clearly the most volatile.
This table shows clearly that direct investment in property has provided not only the least volatile returns over 15 years, but also the highest returns at around 10%. One usually expects a trade-off of return against volatility, albeit if your 15-year period includes a stock market crash of the magnitude we have recently seen, the figures will be distorted.
Also quite notable is A-REITs have proven a disappointment on both counts, suggesting direct property has been the “best” investment over 15 years and listed property funds have been the “worst”. Seems strange, until you consider A-REITs can be sold in panic with the flick of a keyboard, just like shares, and property can’t be, and that the fall in A-REIT prices beginning late 2007 was greater than that of general shares through to 2009 given excessive gearing.
Now, it is important to note at this point that over 15 years, the make-up of the ASX 200 has changed several times and some stocks have bitten the dust. The figures here for A-REITs does not include those that went under after 2007, and there were several. Direct property doesn’t “go under”, but direct property investment funds and syndicates have certainly done so in the period. The above table cannot be taken as gospel, but rather as a best proxy comparison.
If we narrow down the return comparison from 15 years to the period September 2007, just before the then Credit Crunch sent A-REITs spiralling, to the end of last year, another picture emerges. We might call this "the GFC period":
Fixed interest is clearly the winner, reflecting extensive RBA interest rate cuts over the period. From here, the scope for further cuts is limited and the scope for rate hikes is increasing. Despite a decent rally of late, equities are still under water. And despite an even more pronounced rally of late, the damage done to A-REITs in the period was just too severe. Direct property again stands out.
The table further highlights the relative risk/reward benefits of a direct property allocation in any longer term investment portfolio. Let’s look at another one:
Leaving aside for now the volatile equity and A-REIT classes, we see here a comparison of returns over a decade of prime property investment against bonds (5-year), the SMSF's favoured post-GFC investment of bank term deposits (3-year), and the RBA cash rate. Term deposits have clearly been a cracker of an investment for SMSFs, post-GFC, but returns are now waning, particularly following last year’s RBA cuts. By contrast, direct property has largely sailed on through.
Direct Property Investment
Direct property investment can loosely take three forms: your residence, a separate residential or a commercial property which you let, or an investment in a direct property investment syndicate or managed fund.
In the case of your residence, this only becomes an “investment” for yourself, other than your children, if your intention is to one day sell the family home and trade down to something else. Usually we would exclude your residence under the label of “investment property”. As far as direct brick & mortar investment is concerned, investments here might range from one flat to a block of flats, or a factory or warehouse and anything beyond, depending on your means. For those on lesser means, tapping into the returns on offer from property investment in larger residential or commercial assets means becoming an investor in units of a syndicate or fund. Syndicates, again, are usually for the more wealthy, so let’s cut our discussion down to direct property funds.
A comprehensive explanation of direct property funds is available by sourcing an FNArena article from 2011, Unlisted Property Trust Investment.
The important feature of direct property fund investment is, as indicated by the tables and graphs above, a steady return over time. Most direct funds involve investment over several years, which would suit an SMSF anyway, but investors are not locked in and can exit at any time. Direct funds are nevertheless unlisted, so cannot be traded on a secondary market as can REITs.
A steady return does not necessarily imply no risk, but rewards do not come without some level of risk. A lack of secondary trading market is one reason volatility of returns is reduced in unlisted funds which, as we have seen, is not the case for shares, and not the case for listed REITs which are effectively traded as shares. High-yield shares and REITs have provided a fabulous trading opportunity over the last year or so but only because they were so knocked down in the first place. All REITs suffered sell-offs beginning in 2007 which sent their listed valuations down to below, and in some cases well below, the net tangible asset (NTA) value of the properties in that REIT's portfolio. Impressive rallies for favoured REITs in recent times is largely a reflection of that gap back to NTA value being closed, now that the GFC dust has settled somewhat.
REITs have mostly now returned to more benign yield levels, thus limiting the scope for further sharp rallies in valuation. Offshore funding for banks is now returning to more benign levels of cost, reducing the pressure on Australian banks to compete for deposits. On low RBA cash rates, bank term deposit rates have begun to wane. Fixed interest investments such as bonds have largely run their course on increased valuation, given limited scope for further RBA cuts.
The share market, on the other hand, might just be looking good. But the rally-back to date has mostly been driven by high-yield stocks, the valuations for which are now becoming stretched. If the ASX 200 is to continue upward, a switch out of defensive yield and into cyclical risk is inevitable. Yield-seekers may thus be looking at capital underperformance ahead.
All the while Australian total superannuation fund assets are growing, not just in absolute terms but also as a percentage of Australia’s GDP:
If we consider a "default" domestic super fund portfolio to be weighted as in the following table, we can conclude that there is likely a growing demand for direct property fund investment:
From June 2002 to June 2012, the assets of Australian super funds grew by an average compound rate of 10.46% as the Australian GDP grew by 3.07%. “With an approximate 10% allocation to property that is looking to be increased by a number funds, prime quality [assets] may become increasingly difficult to attain should superannuation funds continue to post comparable growth rates from this exceptionally large $1.46trn asset base”, suggests property fund manager Charter Hall ((CHC)),
SMSFs thus looking to find an alternative to bank deposits and/or an overweight to defensive yield stocks to drive portfolio growth in a more risk tolerant market would be well served by considering direct property investment as a proportion of a balanced portfolio. Investors already holding defensives or REITs on high entry yields will continue to enjoy such yields, but those yet to enter are now running into yield compression.
Yield compression occurs when the price of the underlying asset rises against the same value of dividend/coupon, ensuring a lesser annual yield on investment. High yield Australian stocks and REITs have all seen substantial price rises recently and government bond prices are reaching the last hurrah of what has effectively been a thirty-year rally from the bad old days of double digit interest rates.
While commercial property held by REITs and unlisted property funds is sourced from the same pool of assets, REITs have been able to rally sharply in price in recent times for the simple reason REIT prices were so knocked down post 2007. Yield compression could not kick in until prices closed the value gap to NTA, but the compression is now occurring. Unlisted funds could not come under attack from panicked investors, hence yields on unlisted funds have remained relatively more stable over the GFC period.
As the demand for investment property grows through weight of funds under management and lack of attractive investment alternatives, the greater will be yield compression ahead for unlisted property funds.
The Argument For Industrial Property
Commercial property funds are divided into three classes: retail, office and industrial. Clearly all relative sectors of the Australian economy have suffered as a result of the GFC, through consumer deleveraging, loss of jobs in the services industries, and the decline of the Australian manufacturing sector. The strength of the economy post-GFC has been dominated by mining and energy development.
Spending in mining has begun to peak and spending in energy will peak in the next two-three years. While progress has been slow, the focus of the economy is now shifting away from the resource sector and back to “non-mining” sectors through easier monetary policy from the RBA and a slow return to risk appetite in the global economy. Retail spending has begun to pick up. Service industries have begun to re-employ. While the manufacturing sector in Australia may never recover from what is now a structural shift in the value of the currency, manufacturing is only one sub-sector of that which we call “industrial”. The following table shows total return by property asset class in 2012. As we can see, industrial returns were only just pipped by office returns:
Despite the strongest 2012 result, office returns began to soften towards the end of the year. On the other hand, the take-up of industrial premises improved towards the end of the year. A recent survey by JP Morgan found the bulk of fund managers expecting industrial to be the top sector over 2013. Historically, industrial rentals have a strong relationship with the performance of the share market. With a strong result in 2012 (ASX 200 rising 14%), an uplift in industrial rental growth appears likely, suggests Charter Hall.
The mining and energy industries may be at or near peak development spend, but this simply means the resource sector will now transition from a period of strong growth to strong production. Rental growth on properties within all three classes across Australia was a feature of 2012, but the stand-out state capital was Perth. Oversupply meant Brisbane did not perform quite so well, but supply has since decreased notably, suggests Charter Hall.
Property rentals in the high population states of NSW and Victoria have underperformed rentals in the “emerging” states over the past decade, yet institutional investors have remained steadfastly overweight industrial property in NSW in particular over the period. Old habits are hard to break. Indeed, Charter Hall points out that the industrial weighting to NSW is almost double that warranted by the weighting of the NSW economy within the Australian economy.
In short, if we assume an ongoing softening of global fear, improvement in the global economy, and a return to risk appetite, the Australian non-mining economy should also start improving to fill the gap left by the decline in the mining economy. The RBA believes the early signs are positive, and hence has not decided to cut interest rates in 2013 so far.
At this stage of the cycle fund managers expect the industrial property sector will offer greater growth potential ahead than retail or office. Overweight investment in the legacy states of NSW and Victoria suggests fund managers will be looking to diversify their property portfolios into the other growing states.
While investors may be put off by a longstanding association of manufacturing with “industrial”, manufacturing is only one sub-sector under the “industrial” banner. The slow decline of manufacturing is being rapidly now offset, for example, by the rise in the sub-sector of “logistics”. The demand for distribution centres and other logistics-related property is being driven by the rise in on-line commerce.
Charter Hall is one property fund manager offering unlisted direct property investment funds. There are many others. The successful subscription of Charter Hall’s direct industrial fund DIF 1 in 2011 has led the manager to open for investment DIF 2 with an equity raising period closing end-2014 and a funds target of $200m. DIF 2 will target an average 8% per annum distribution yield with a total rate of return on the fund over seven years of 12%. Minimum retail investment is $10,000.
To date DIF 2 has acquired two properties – the Australia Post Distribution Centre in Melbourne and the Coles Distribution Centre in Perth, with a nod to logistics and diversification into WA.
For more information, readers are advised to contact Charter Hall.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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