What is Direct Property Investment?
Direct property is the term commonly used to describe real estate investments, whether it be the purchase of a commercial, industrial, retail, bulky goods, residential or any other property asset, which can either be held directly (direct ownership on the title) or indirectly through collective ownership vehicles such as managed property investments: funds, trusts and syndicates (Property Funds). Investors in Direct Property Investment Funds, including those offered by large institutions, public and private companies, are wholesale and retail (Mum and Dad) investors.
Over the last two decades, Direct Property Investment has grown dramatically and has become a core investment class for the growth of wealth through strong risk adjusted returns, while also providing a stable source of income through regular distributions of underlying rental income.
Features of a typical Direct Property Investment Fund:
Tangible Assets – Properties can be clearly identified with the Property Fund Manager disclosing how they plan to manage the asset(s) and any intention to acquire further assets.
Fixed Term - The investment will generally have a fixed life, usually between 5 to 10 years.
Liquidity – As property is a relatively illiquid investment, unlike listed shares which can be readily converted to cash, Direct Property Investment Funds are generally an illiquid investment. In other words, your investment in a fund cannot be withdrawn until the termination of the fund. However a number of Property Fund Managers have developed innovative features to provide liquidity options to those investors needing to exit their investment early.
Asset sale – If or when a property is sold from the portfolio, you will be entitled to receive your share of the net proceeds of the sale (in proportion to your initial investment contribution), including any capital appreciation.
Gearing - Debt financing on the asset(s) will typically be between 40% to 60% of the value of the assets held in the portfolio. These borrowings are typically non-recourse loans, meaning the fund’s liability is limited to the asset(s).
Asset valuation - Typically property investments are subject to regular appraisal based valuations. Like all investments, property assets can appreciate and depreciate in certain markets.
Listed v Unlisted:
Property Funds can either be listed or unlisted. Those which are listed on a securities exchange ie (ASX) are commonly called Australian Real Estate Investment Trusts (A-REITs). The units in the Property Trust are regularly traded, providing liquidity. Unlisted Property Funds generally do not have a market place for the trading of units.
An unlisted Property Fund usually consists of a unitised structure, with a fixed investment term and transparent investment purpose. The structure can either be open–ended meaning that the Fund Manager can continuously raise new money at any time (through the issue of new units) for the purchase of additional assets for the investment portfolio, or closed-ended (no more units can be issued) with a fixed and defined investment period in which money can be raised (typically 6 to 12 months). Returns from unlisted Property Funds are typically less volatile for investors compared to A-REITs and are known for providing a consistent inflation-linked income stream.
Investors in A-REITs, where units are listed on a stock exchange for trading, are able to determine the current market value of their investment and trade those units in the open market place. As a result, this investment, although liquid, can be far more volatile than unlisted vehicles meaning its value can fluctuate both up and down more readily.
Advantages of Direct Property Investments:
• Property total returns have averaged 10% over the last 10 years. These returns are very attractive for superannuation funds or investors looking for an annuity style income stream from an underlying asset(s), (such as those entering retirement phase).
• Stable and secure income streams that are typically paid monthly or quarterly from the rental income of underlying properties within the portfolio. This income is typically supported by leases to commercial tenants. This provides certainty of cash flow as rental income is typically “locked in” for a predetermined period as a result of the underlying leases.
• Participation in capital growth of the underlying asset(s). Improving market conditions, strong demand and a stable economy have resulted in strong growth in the underlying assets of Property Funds in the past.
• Tax deferred income and favourable treatment by Australian taxation laws to direct property investments. Investors will often receive “tax-deferred” distributions through asset depreciation benefits, meaning only a portion of the distribution will be require to be declared as taxable income in the year it is received. Thus, direct property becomes a very attractive investment mechanism through which investors can obtain both income and capital growth tax effectively.
• Less volatility than A-REITS as Property Funds are unlisted, therefore they are not impacted by speculation and listed market volatility like the A-REITS, which are listed on a stock exchange. As such, Direct Property Investment values reflect the value of the underlying assets, not market sentiment.
• Reduced downside risk and strong risk adjusted returns. Over a substantial period of time, Direct Property has a lower incidence of downside risk (the propensity of an asset to decline in value) compared with other asset classes. Furthermore, risk adjusted returns are often superior to other asset classes.
• Low correlation with other asset classes providing effective diversification benefits. This means your investment in direct property is a ‘real asset’ and performs and reacts in a different manner to varying economic conditions compared to other ‘financial asset’ investment classes such as shares and bonds. For this reason, Direct Property is an essential component in any portfolio to broaden the investment base and reduce exposure to the market fluctuations of traded financial assets.
• An inflation hedge. The income derived from underlying tenants generally has a minimum annual increase linked to inflation or above. This means both the income and underlying asset value of direct property tends to appreciate with inflation This ensures that the real value of your investment should be preserved.
• Professional management by skilled and experienced managers who select and properly manage the Fund’s underlying properties, thereby ensuring maximum performance from the asset and return on your investment.
• Tangibility – the bricks and mortar factor where you can actually visit the property owned by the fund!
Important points for consideration:
• Medium to long term nature with an investment period typically of between 5 to 10 years.
• By nature these investments are illiquid. Liquidity is dependent on the investment you have participated in and it maybe hard to realise your investment before the assets are sold or the Property Fund is wound up. Some Fund Managers have addressed this through providing partial withdrawals and redemption underwriting mechanisms.
• Determination of value. Property Funds generally do not provide daily unit pricing. Unlike listed stocks where unit prices change daily, Property Funds require an independent valuation to be undertaken on the asset(s) periodically (usually annually).
Identifying an investment opportunity:
Just like any other investment, choosing a Property Fund requires careful consideration of a number of factors. Below is a list of some points to consider when investing:
• The Fund Manager: The strength, expertise and track record of the Fund Manager should be considered. Note that the Fund Manager is often called the “Responsible Entity”. The PFA believes all Fund Managers should hold an Australian Financial Services Licence (AFSL), authorising the company to manage assets on behalf of the investors.
• Diversification: Exposure risk to one property sector can be reduced by an increased number of properties in the portfolio, where they are located and their types (such as retail, commercial, industrial), as well as the quality and number of tenants.
• Property characteristics: Does the building present well? Who are the tenants and what are their lease terms? Have all significant property related risks been identified? Have repairs & maintenance been allowed for? Is the property located in an area of demand which may allow for capital growth?
• Borrowings: Does the rental income comfortably service the debt levels? Are the debt levels appropriate? Has the debt been borrowed for an appropriate fixed term to prevent additional risk? What is the likelihood of the Fund Manager being able to refinance?
• Fees: Are the fee structures and fees paid to the Fund Manager, financial advisers and third parties in line with industry standards / competitors? Does the fee structure reward the Fund Manager for good performance?
• Independent Research: Has independent research on the Property Fund been produced? If so, what rating has the investment been given? How does that compare to other investments?
• Early exit: If liquidity is important, what liquidity mechanisms are provided? If not, is the investment term appropriate to your current and future needs?
• Tax and Structure: What are the tax advantages and how can you benefit from these? Can superannuation funds invest?
• Capital Growth Potential: Carefully examine the capital growth prospects and disclosure document assumptions (if any).
• Disclosure and transparency: Has the Fund Manager adequately disclosed everything reasonably expected? Are you comfortable with how the investment will operate? Read the Product Disclosure Statement carefully.
• Financial Engineering: Are the distributions being paid sustainable from the assets' income streams or are they artificially enhanced by repayment of capital, fee discounting or additional debt draw downs?
• Market Exposure: Which property sector does the investment have exposure to and what are the long term prospects for that investment class?