The Long Term Outlook for Property Securities- Part 2

In last week’s column we looked at a number of factors associated with increasing the earnings per share for listed property companies.  This week we will look at some additional factors and then attempt to predict what will happen over the next ten years.

Asset management fees can come from two sources, namely the management of trust assets and the management of assets owned outside of the trust.  There has been a trend for some property trusts to sell the property management rights to another party, rather than manage the assets on a day to day basis themselves.  For example, the Newmarket Property Trust is managed by St Laurence.  The rights are a valuable investment in their own right, particularly if the asset management company has a sufficient share ownership stake in the property company to block changes to the asset manager.

In recent years property trusts have increased their gearing.  This multiplies the underlying rental growth rates, which could be positive or negative.  Australian average gearing rate is currently around 37%. 

Risks increase with price and gearing, as does development activity and increasing off shore exposures.  However the largest sources of increased risk are high valuations and increased labels of gearing.

Pricing is the biggest risk.  If we take the Australian situation, there is much more risk at current yields of 5.6% than there was a couple of years ago when yields were 7.5%.  If yields moved from the current 5.6% level to 7.1%, the share price would fall by over 21%.  If they moved to 7.5% then the fall would be around 25%.  Strangely people are still buying property shares as they consider them a “relatively safe” investment! Putting this into perspective, this is the level of fall that would be expected from an aggressive portfolio with 75% being invested in growth assets (primarily shares).

Gearing is a major source of risk.  Gearing multiplies and gains or losses.  It also introduces substantial interest rate risk.  Sure, most trusts would hedge their interest rates risk out for say four to five years, but what happens in years 8, 9 and 10.  A 2% move in interest rates could reduce distributions by 25% in a 50% geared trust.  This is a much greater hit, than what would occur from falling rents in a diversified portfolio.  The impact of rising interest rates could more than offset any rental growth over a ten year period.

Even going offshore does little to diversify away any of these risks.  If US interest rates rise substantially, they are likely to do so world wide.  Property securities carry high levels of gearing just about everywhere.

When we add together the current yield (5.6%), growth in distributions, and the impact of valuation ratios we see the following.  If the 2016 yield was 7.1% there would be a 2.4% pa fall in returns over ten years.  If the yield was 5%, there would be a 0.9% rise in returns.  And if the yield rose to 9.5%, this contributes to a 5.5% pa fall in returns over ten years.  There is a 5% chance of this occurring!

Putting this into perspective, at current yields, the likelihood of negative returns from property is only slightly less than that for investing in shares, and the current yield from New Zealand shares is close to that of property companies.  It is probably even riskier for investing in direct property.  The subtle difference is that you know what your property shares are worth on a day to day basis, unlike direct property when the true worth is only known on disposal.