The journal of superannuaTion managemenT• FS Super

24 www.fssuper.com.auVolume 04 Number 02 | 2012

Brett macgillivray, affinity funds

Brett Macgillivray is a director and responsible officer of Affinity Funds Management Limited, which he co-founded in 2004. Affinity is the holder of an Australian Financial Services Licence and a specialist manager in alternate asset classes with emphasis on mortgage and property

Invesment

residenTial properTy – an invesTmenT asseT class?Brett Macgillivray

The scope of this paper is to consider Australian residential property as an investment class for institutional investors. It is not my intention to analyse the measurement and extent of growth and influences on the sector, but rather extrapolate from the commonly accepted figures and suggest what they mean to the potential of sector as an

investment product.This paper will consider the size, scope and investment features

of the residential property sector. What are the potential benefits of investment in the sector? Why are there few, if any, investment products specialising in the sector? How can effective investment be achieved?

The marketThe Australian residential property market is by far the largest asset class in the country – estimated to be valued at $3.5trillion, of which owner-occupied property represents approximately $2.4 trillion, with the balance being residential investment property. The residential property market is about three times the size of the stock market, and dwarfs the commercial property market (valued at about $600 billion).

The size of the market provides it with dept and investment opportunity. On the basis of size alone the market should not be overlooked. I would also argue that the centrality of property as a “Mum’s and Dad’s” investment means that residential property should not be ignored. Individuals, the retail investors or clients of the institutions and funds mangers, accept the importance of residential property investment, which they feel they understand. What then of its actual performance?

performanceThe most important aspect of performance is in the context of competing asset classes. ANZ has recently published a report1 which showed comparative asset performance as shown in Figure 1.

The information in Figure 1 received considerable press at the time but it did take into account the beneficial taxation treatment of owner occupied houses – if we allow for that, the rate of return for an investor in owner occupier housing, is between 9.6% and 12%. Russell Consulting in a 2011 Report2 has also looked at comparative returns – see Table 1.

On either assessment, the returns on residential property are impressive – particularly in comparison with other asset classes3.

Russell found that residential investment property achieved the highest return (before tax, after costs) of 10.1per cent a year for the 10-year period, while Australian shares returned 8.4 per cent a year.

volatilityThe property market has a volatility of something in the range 3–6%4 which can be compared to volatility of shares of over 25%. Volatility can be attractive as it creates the potential for large short term gains. However the ability to pick stocks to reflect that potential is perhaps best seen in investment managers returns – as we know, there is little prospect of consistently picking the market. So a good percentage of investment assets should be stable asset class with consistent growth history – limiting investment downside and creating consistent growth within the portfolio.

Volatility is to some extent a reflection of liquidity – the less liquid the asset the less likely it is to suffer significant, short term rises and falls – so liquidity must be taken into account when assessing the asset class.

assets. Prior to establishing Affinity, he was a partner in legal firms for over 15 years, specialising in managed investments, banking, property and finance law. Affinity has managed funds for institutional and retail investors. Funds have included the Commercial Mortgage Trust, Split Income Fund, Special Opportunities Fund and the Affinity Property Fund.

FS Super The journal of superannuaTion managemenT•

25www.fssuper.com.auVolume 04 Number 02 | 2012

Investment

inflationary hedgeAs a real asset, property is a natural inflationary hedge. An analysis of returns indicates that the real returns of property average 2.3%5. This is interesting because infla-tion impacts on interest rates and interest rates impacts on housing prices. The lesson is that impact tends to be short term with the underlying growth trends continuing.

low correlation to equitiesIf property is being viewed as an instrument to maximise portfolio performance then it is crucial that it is not closely correlated to equities. Many studies have indicated that there may be a lag involved – a strong equities market, followed one or two years later by a strong housing market – although some suggest “no significant correlation or co-variance risk between them”.6

Interestingly some portfolios include listed vehicles as diversification from equities, which they are of course not.

challenges facing residential property investmentOther than pure income returns through securitised notes, the residential property sector has been largely unavailable to institutional investors. Given the sector’s size, performance and stability, one needs to question why investment managers have not participated in the returns in a sector which has comfortably outperformed other asset classes. Typical perceived deterrents are:

costsInvestment in real property in Australia is very expensive, with far greater transaction costs than other investments – both on acquisition and disposal. With an average stamp duty on purchase of 5.5%, legal costs and process of acquisition, property maintenance costs, land tax, disposal costs (agents fees of 1.75%+ and the selling costs of advertising and marketing), property management fees, insurance and incidentals costs, the transaction and holding costs can easily amount to 8-10% of asset value. These costs exist for direct purchase, pooled funds and REITS.

accessThe best performing and most stable of the property asset class is owner occupied residential property and this cannot, to date, be accessed by institutional investors. Further, to achieve the benefits of residential property investment, well diversified significant portfolios are required and few exist.

diversification Direct investment consumes considerable capital (it is ‘lumpy”) and usually with limited diversification. Property funds are established to provide diversity but they are rarely in the best performing (residential) class due to asset management issues associated with privately held property (residential tenancies).

liquidityTypically liquidity is provided listing on the ASX, and this carries a cost – the cost being price volatility, the loss of the potential advantage of a low correlation to equities and the market discount to net tangible assets.

reputation riskDirect investment in residential property leading to tenant management or selling up issues can cause corporate concerns, particularly with direct investment.

management and maintenanceParticular issues exist in the management and maintain-ing of residential property when compared to commer-cial properties and other asset classes.

distribution In order to take advantage of the asset class the investor needs a large, fungible and well diversified portfolio. There are inherent difficulties in building a substantial portfolio, as very large investment is required as well as considerable management infrastructure.

figure 1. asset average returns

Table 1. returns before tax and after costs

10 years 20 years 25 years

Australian shares 8.40% 11.00% 10.80%

Residential investment property 10.10% 10.20% 11.60%

Australian REIT 1.90% 7.00% 8.20%

Fixed interest 5.80% 8.20% 9.80%

Cash 3.80% 4.30% 6.10%

Global REITS 2.80% 7.40% n/a

Overseas shares -4.00% 5.60% 6.90%

The quote

The best performing and most stable of the property asset class is owner occupied residential property and this cannot, to date, be accessed by institutional investors.

The journal of superannuaTion managemenT• FS Super

26

www.fssuper.com.auVolume 04 Number 02 | 2012

Investment

a future investment class?Most would agree that residential property shows all the signs of sound, prudent and productive investment with excellent diversification features for existing portfolios. But there are limitations. What the institutional investor market requires is the creation of investment products which access the all the benefits of the residential property market, whilst addressing all or most of the negatives.

There is a challenge for developers of financial products to create an investment which addresses the challenges of residential investment and allows for inexpensive and large scale asset acquisition to a level that the advantages of residential property are realised.

In the writer’s opinion, a structured product is more likely to achieve this result than direct investment by a fund. Further a structured product, by not being a direct investment, has the opportunity of minimising the prohibitive costs of acquisition, increasing distribution potential and overcoming potential reputation issues. Equally, for institutional investors, there is a challenge to be accepting of a high performing but less liquid asset class within their portfolios, and take advantage of the diversification it can create. What a structured product can do is create certainty as to the term of exposure to the investment, which would in part address liquidity issues. The writer is aware that a number of institutional investors are considering the asset class anew, particularly given the volatile and unattractive returns provided by equities over an extended period. fs

Notes

1. ANZ Asset Returns: Past Present and Future, 6 October 2001

2. Russell Consulting ASX Report 2011

3. Taking the ABS figures on the writer’s own calculations the appreciation

of property prices over 50 years has averaged 8.6%. Each set of

figures uses slightly different bases for calculation but the results are

not to dissimilar.

4. Research figures vary between 3% and 6% - suffice to say “property

is not volatile” on the evidence of long term figures. Of course to take

advantage of the low volatility one needs a large diverse portfolio.

5. Australian average, Productivity Commission ReportFirst Home

Ownership Report No. 28, March 2004 page 17

6. ProfessorRR Officer – JASSA The Finsia Journal of Applied Finance

Issue 1 2009 “Observations on Residential Housing”page 33.

7. P Braddick , ANZ Bank Economic and Property Update Perth

November 2011

8. ANZ Housing Market Assessment 2010

9. BDMA FUNDependent No 3 December 2010

is there a bubble?The current status of the residential property market is not an explanation for the lack of investment in the sector; however it is reasonable to ask if the market is overvalued. Issues of affordability and international comparisons have been at the forefront of these concerns. Of interest is recent analysis questioning the use of simple “house price to income” ratios7. It is worth noting:

• since1985 all the increase in house prices has been covered by increases in incomes and reduced interest rates,

• affordability has improved,

• prices have eased,

• population growth is strong (recovering after a de-crease in migration in 2009/10),

• we continue to build less than we demand (by about 70,000 properties per annum8),

• home ownership is encouraged by the taxation system (capital gains tax and negative gearing),

• home mortgage defaults remain stable at under 0.5%,

• strong underlying economic fundamentals.

Insofar as international comparisons are concerned, I suggest that markets cannot be reasonably compared across nations due to the varying property focus of the nation, direct and more subtle differences in tax treat-ments, the geographical distribution of properties affect-ing averages, and nature of dwellings. Our self-correct-ing market has all the signs of sound fundamentals and is starting to come out of a period of easing.

overseas experienceOverseas fund managers have experience in investing in residential properties – mostly through ownership of large blocks with multi-tenancies – known in the US “multifamily” trusts9. Estimates are that up to 20% of institutional property investment in the US is in resi-dential property. Australia fund managers are yet to develop similar products. We can only theorise why we have not followed with similar structures. Perhaps it is due to the cost issues (typically greater in Australia) and possibly the efficiency of our property and prop-erty development markets. There is also somewhat of an aversion to new products.

There is also a view that if the retail client owns property further property investment in their managed fund creates concentration of assets for that client. Of course that is not reasonably the manager’s concern in assessing its highest performing portfolio mix and not all will own residential property. Most importantly, the performance of residential property is not the same as the performance of each individual property. What the institutional investment creates is access to the performance of the sector through a large and diversified portfolio.

The quote

What the institutional investor market requires is the creation of investment products which access the all the benefits of the residential property market, whilst addressing all or most of the negatives.