(This story was originally published on 17th February, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

- Post-GFC, investors are seeking safer risk/reward profiles - Managed property remains a popular investment - Unlisted trusts have experienced much lower return volatility this past decade than other assets - The burgeoning pool of SMSF investment is adding unlisted trusts to balanced portfolios

By Greg Peel

In late 2007 the price of units in Centro Property Trust ((CNP)) collapsed. The fund has since been restructured and has managed to survive, but the Centro shock reverberated through the listed unit trust market at that time. All listed REITs (real estate investment trusts) suffered similar rapid de-ratings, as did equivalent infrastructure and other trusts and companies which relied on significant gearing levels to sustain distributions. The broom swept right through to the likes of child care centre operator ABC Learning, for example.

Yet the fall of Lehman Bros and the GFC as we now know it were still a good ten months away. What was occurring in late 2007 was what was then simply called the global “credit crunch”. The collapse of the US subprime mortgage security market had led to fear and distrust amongst banks and financial institutions which then choked off the availability of credit. Many REITs and other funds were very highly geared – a risk/reward trade-off which had seemed safe enough in the “free money” and property boom days of the earlier noughties. Centro, for one, had exploited the tail of that boom, snapping up lower quality US shopping centre assets and extending leverage even further than most. It was fun while it lasted, but the game was up.

Here we are over three years later and still there is a general caution being exhibited by investors with regards to property trust investment. In the ensuing period, trusts have gone to the wall, others have hung on and consolidated, and all that have survived have reduced their gearing levels, divested of assets and shored up the quality of their portfolios. Some have seen solid bounces in unit price from their near-death depths, but still most REITs are being valued by the market at less than their net tangible asset value, which in theory implies a negative risk/reward valuation. Yields may be very attractive in many cases, but faith has been shattered and will clearly yet take some time to be restored . Yields might be tempting, but are they sustainable? Can it all go down the tubes again?

Listed REITs (and listed trusts of any sort) provide a level of comfort to investors in the areas of liquidity and transparency of unit price (perceived capital value). Once in, the listed REIT investor is happy in the knowledge that he or she can get out again at any time during exchange trading hours and that there will be at least someone on the other side ready to accept the unit volume. Trading in REITs and indeed any listed stocks in the period 2007-08 nevertheless came under scrutiny when the activity of “naked” short-selling was exposed given just how quickly stocks and trusts were being de-rated. The emotion of panic was also prevalent, and as such many REIT holders found themselves with substantial losses before they even had time to react. Such is a market.

But for those wishing to invest in property, and more specifically managed property trusts, listed trusts have not been, over time, the sole choice. Of course one can simply buy a property oneself but most of us don't have the wherewithal to buy whole shopping centres, warehouses, office blocks or townhouse developments, even if we want to. But we can buy a “share” in a fund that does exactly that, being a unit in a trust, with only a small investment forming part of a pool. We then share proportionately in the yield on that property, which in simple terms means the rent, and in any capital appreciation of that property, depending on how the trust is structured.

Some trusts buy several properties and sit on them, others “recycle” properties by buying at a good price and later selling at a better price (hopefully), and most specialise in one particular property subset (eg retail, office) while still diversifying risk through various asset purchases within that subset.

We can choose to make such property investments via listed trusts or via unlisted trusts. Listed trusts give us aforementioned liquidity and transparency advantages – we can get in or out whenever we choose and we always know what the price is – whereas unlisted trusts typically mean making an initial investment and having no recourse on that investment until the trust provides a redemption opportunity either at a pre-determined date, or on wind-up or sale of assets, in what may be several years time.

The question might thus be: why would we lock our money away like that? If we want to invest in property why not just stick with transparent, listed REITs? Well a clue might be evident in the following chart, provided by Charter Hall:

The above charts the value of $100 invested in December 2000 in four different indices of asset classes available to Australian investors – listed REITs, unlisted property trusts, listed local shares and listed overseas shares. The valuations are “accumulated” such that in each case distributions (dividends) are accounted for to provide yield and capital return comparisons on an apples-to-apples basis. There are several observations we can make.

Firstly, we can track the boom period of the Australian stock market through to 2008, its subsequent GFC tumble and more recent recovery. We can also see that REITs follow a very similar pattern but that property out-boomed stocks in the run-up to the GFC, reflecting high levels of leverage, and then out-busted subsequently as the whole geared trust model collapsed. We can also see the reflection of lingering investor caution and low valuations in the comparative movements since.

We note that overseas shares appear to have had nothing like the same rocky ride but have proven the least beneficial investment, but we must remember the counter-movement of the Australian dollar in the period is reflected in the comparative return.

The real stand-out, however, is the unlisted property trust curve. One can see that perhaps those favouring listed REITs as an investment might have been laughing from their yachts at their mates stuck in unlisted trusts in the 2004-07 period on a comparative return basis, but we can also see just how quickly they would have been laughing on the other sides of their faces. Unsurprisingly, unlisted trusts also suffered a valuation drop in 2008 but nothing as spectacular as the other asset classes. Valuations are also now not far from peak levels which is a better result than share investment and a much better result than REIT investment.

Now, we know that the “price” of an unlisted trust is not controlled by the market on an exchange so it must be controlled by the managers of the trust. So the skeptical might immediately jump in and suspect that the lack of volatility in unlisted trust values reflects only an unwillingness by those managers to “fess up” to falling property valuations or credit difficulties and hence “smooth” unit prices to their advantage. Indeed, while 2008 saw the death of many a listed trust, it also took out many an unlisted trust. Such fatalities are never reflected in index charts like those above.

So unlisted trusts are by no means infallible, but we do need a little bit of history here.

In the previous century, unlisted property trusts were typically “closed-end” funds. A syndicate would buy property and then subsequently issue units in that fund once to willing buyers. Those units were only redeemable at the time the fund decided to liquidate. But by 2002 the greater number of unlisted funds had become “open-ended”, which typically meant there were both windows of opportunity to buy (more units could be issued down the track) and windows to redeem (other than simply on liquidation). These developments made unlisted trusts more friendly for the “wrap” funds which were growing in popularity among wealth managers at the time. And to satisfy wrap requirements, unlisted fund managers published a perceived unit price each day.

To that end, it was not altogether possible for fund managers to “fudge” their unit prices. Thus what we really see in the chart comparison might be a reflection of any number of things – lack of panic selling in unlisted trusts given no daily access to trading in units; no possibility of short-selling unlisted units; the ease of “going to market” with a poor risk/reward portfolio for listed trusts; the pressure on listed trusts to outperform and thus gear up further and further; or even too many cocky types thinking this listed REIT thing is all a bit of a lark. Whatever the reasons, we must again note that it was not just listed REITs that hit disaster in 2008 but many unlisted trusts as well.

In some cases that meant suspended redemptions – the greatest fear of any fund investor. There was uncertainty surrounding property valuations and uncertainty surrounding credit availability. It was not a good time for any form of trust.

But let's go back and focus not on the outperformance of unlisted trusts post-2007, but the underperformance prior. Unlisted trusts don't buy properties that are in any way different to those bought by listed trusts, but in setting up an unlisted trust the managers do have an idea of what their targets are on total investment and yield and what sort of risk/reward balance they are trying to achieve. They are not as much at the mercy of the market as listed trusts. In the year 2000, no one was predicting anything like the property boom ahead, the cheap money climate ultimately pervading or the madness of far too relaxed leverage rules. In other words, unlisted fund managers were simply looking for the kind of modest but consistent returns which had been offered by the property market throughout history – the sort of risk/return profile which suited the longer term investor.

That typically meant beating the return on a government bond and achieving about 10%pa or better (which is the long term stock market return) rather than the 20-25%pa extraordinary returns which were available in the noughties (assuming you got out quick).

Note the following graph:

I apologise that this is a bit hard to read, but simply take note of the red line which represents the one-year rolling return on unlisted property trusts against the right hand axis, which is percentage of return. The peak in return prior to the 1992 recession (at the height of the previous commercial property boom) is just under 30% and the peak prior to the GFC is just on 20%. Outside of those periods, the average would be something between 10-15%.

A similar chart for listed REITs would no doubt look a lot wilder, and if we picked just one individual REIT to study we might see movements off the dial.

What we can deduce from the graph, looking at the most recent movement, is that returns on unlisted property are trying to gravitate back to the mean. Like listed REITs, unlisted trusts have been forced to reassess gearing levels and asset quality, but in reality that simply means returning to the sort of risk/reward profiles of the less heady days gone by. And unlisted property trusts are once again growing in popularity.

The growth in popularity of unlisted trusts post-GFC coincides with the growth in popularity of self-managed super funds (SMSF). It was as a result of poor returns from fee-laden retail super funds through the 2002-03 very mild recession in Australia that SMSFs really hit the radar. Quite simply, investors were mad as hell and they weren't going to take it anymore. Rather than entrusting their hard-earned to any Joe who hung out a “financial adviser” shingle and took (legal) backhanders to steer investors towards certain funds, super investors were deciding that whatever their experience or lack thereof in financial markets, they'd rather control their own money.

Government regulators, cognisant of Australia's compulsory super laws, decided it was incumbent upon them to make SMSF investment simpler in the ensuing years. And the fact the retail super industry has just been carefully scrutinised by the regulators, and the whole MySuper idea floated, is testament that retail super funds had not learned any lesson on the fee front. Unfortunately it took a GFC to open a few eyes.

The end result is that there is more money now invested in SMSFs in Australia than there is in retail funds, industry funds, public sector funds or any other type of super fund category. And the SMSF proportion is growing with a bullet. Net super investment totalled $1.3 trillion in 2010 and that is forecast to reach $2.5-3.0 trillion by 2020.

One feature of the stock market rally from early 2009 and throughout 2010 is that movements were made on low volumes. Retail investors were very much once bitten-twice shy and too shell-shocked to note the rising market and jump back in. Fund managers are beginning to report a more recent pick-up in flows but one thing is certain – retail investors will never look at the stock market the same way again. Hard lessons learned include the need to diversify risk, the need to keep debt at manageable levels, and the need to be satisfied with solid but modest returns. Greed is not good.

The property market in Australia has not suffered as badly as those overseas nor, in valuation volatility terms, as badly as the local stock market. That is, of course, except for listed REITs. But retail investors, and particularly those choosing the SMSF path, know that a diversified portfolio includes bricks and mortar in some proportion. Enter the unlisted property trust.

Property fund manager Charter Hall estimates that of the super investment flows into managed property recently, half has been allocated towards those supposedly undervalued REITs while the other half has sought unlisted investment as a counterbalance. Unlisted trusts can't be “undervalued” on entry because the initial price is set by the manager. But today's super investor is looking for a more modest risk/reward profile, steady returns, and the ability to sleep at night.

I will now use as an example of unlisted property trusts the latest offering from Charter Hall. The Charter Hall Group is itself a listed company ((CHC)) and we are familiar with its two listed REITs Charter Hall Office ((CQO)) and Charter Hall Retail ((CQR)). But the group is also an unlisted property fund manager.

Charter Hall has recently launched an unlisted retail property fund, Charter Hall Direct Retail Fund, intentionally targeted at SMSF investors. The fund has initially been established on a portfolio of six properties totalling $177m in valuation, with the intention of seeking further additions.

Now I know what you're thinking – retail in Australia is in all sorts of strife. And regular readers will know that FNArena has recently been supporting warnings from the smaller pool of analysts who suggest that consumer spending in Australia is not going to return to the frenzied levels seen pre-GFC so it's time to rethink retail stock valuations. Just as super investors have realised it's safer to chase more modest returns, so too have consumers realised it's safer not to just go out and buy something on credit just because you want it now. And current retail sector weakness is not just about the Aussie dollar and the growing (yet still insignificant) popularity of on-line purchases.

The Charter Hall managers also recognise this conclusion, and as such their forecasts for retail spending ahead are not suggestive of a return to the heady noughties. Note the following graph:

This chart was provided by Charter Hall but I drew in those red trend lines. My intention is to highlight the rapid pace of spending growth pre-GFC, 2005-07 compared with the trend from the 2008 crash in spending up to the forecast 2012 level. The reason I've ignored 2009 in this trend is because that was the year of “Pennies from Kevin” and one-off emergency government stimulus does not a trend imply.

Average yearly retail trade growth over the longer term in Australia is 2-3%. While Charter Hall is joining in with most in assuming retail spending will indeed recover quietly over the next couple of years given low unemployment and a resilient economy, the managers are not expecting anything more than a return to longer term averages – not boom averages.

So taking that assumption as a not unreasonable one, we can look at these six properties included in the initial fund. They are retail centres spread across New South Wales, Victoria and Queensland with tenants including Woolies, Coles, Big W, Bunnings, JB Hi-Fi, The Good Guys and Spotlight. In other words, leading retailers in their segments with long occupancy histories. With Australian retail at a low ebb, Charter Hall sees a solid risk/reward investment opportunity.

This is an (intended) seven-year fund with an initial investment period of three years in which units can be issued to investors. Thereafter four years will ensue in which further assets may be added but prior to the completion of the four years an exit opportunity will be provided. If more than 50% of units are redeemed the fund will be wound up. If not, the fund may be extended.

The managers are targeting a yield of 8.0%pa for the first three years (regulations do not allow any lengthier targets). The forecast return on the fund is 10-11%pa over the seven years.

I reiterate that I am highlighting the Charter Hall Direct Retail Fund as an example of an unlisted property trust available to interested investors. Charter Hall manages other funds, and there are plenty of other fund managers out there with their own unlisted offerings.

Those wondering about the “franking” implications of that 8% yield should seek professional tax advice, but note that higher tax paid on distributions is offset by lower capital gains tax on exit of such investments.

For the SMSF or any other investor, unlisted funds provide another means of diversifying one's portfolio in the post-GFC world.

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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