Investment properties: In a low-return world, the case for direct is potent

By Steve O'Malley

Friday 22nd February 2002

NO TIME LIKE THE PRESENT: Direct property investment can enhance returns with little increase in risk

Once viewed as an important component in balanced investment portfolios, direct property investment has declined following concerns about poor relative performance, illiquidity and management intensity.

Direct property as a percentage of total fund manager assets has reduced from around 10% in the early 1990s to about 7% now.

Despite these concerns it would seem the case for direct property in balanced portfolios in today's environment is pretty potent.

Before reviewing the case for direct property in today's low return environment, let's look at its key characteristics, how it's different to other asset classes and how these differences benefit investors.

Direct property offers investors both debt-like and equity-like features - that is security with growth.

Security is provided by periodic lease payments, similar to a coupon stream from a bond, and the growth element comes from the property's residual value, which is variable and resembles an equity interest.

Over time rents will tend to move with inflation, which feeds through to capital value. This is the basis of property's inflation hedging benefits.

What direct property brings to mixed-asset portfolios is its low or negative correlation with the returns generated by other asset classes.

The inclusion of some direct property in a portfolio can enhance return with little increase in risk.

Finally, direct property is highly varied and management intensive.

This means significant out-performance (and under-
performance) is more frequent within property as an asset class, through a combination of astute portfolio selection and proactive value-adding asset management.

However, because there are barriers to entry for investment in quality real estate assets (generally too large for smaller investors), out-performance and security can usually only be achieved by investing in large, multi-asset property portfolios. Witness here the global pattern of property fund management.

Over the long term risk-adjusted returns from direct property tends to fall between fixed interest (debt) and shares (equity). However, in a low return world there are arguments that property's relative risk-return against other asset classes could improve in the future.

For several years investment strategists have warned the high global returns from financial assets of the 1990s were unsustainable and a period of single digit returns was starting.

Four factors have been identified behind these high returns:

the productivity surge flowing from deregulation in the 1980s and technological innovation through the 1990s;
the impact of a sizeable aging baby boom generation starting to save for retirement and chasing a narrow asset pool. Both these forces have benefited equities;
the sharp fall in inflation over 20 years, which has helped both bonds and equities; and
starting point valuations - back in the early 1980s cash, bond and equity earnings yields were very high.

Strategists argue the first two factors still have further to run.

However, falling inflation and its influence on valuations has largely run its course. What might this mean for different asset classes?

Cash: assuming inflation remains around 1.5-2%, short-term interest rates are likely to range around 4-7%, suggesting average cash returns are likely to be low, say at around 5.5-6%.
Bonds: if the secular downtrend in inflation has largely run its course, the best we can expect out of bonds is a running yield of around 6% to 6.5%.
Equities: the return from New Zealand equities is likely to equal the dividend yield (currently around 5%) plus long-term earnings growth.
A reasonable expectation for long-term earnings growth is around 3-4% pa. This suggests a return of around 8-9% pa.
Direct Property: this is one asset class that has not benefited from low inflation. In fact, it has probably turned investors away from the asset class (as the need for an inflation hedge has abated). However, over the next 10 years its fortunes may start to improve relative to other asset classes.

Typical fund managers' direct property funds have income yields of around 7-8%. Direct property also extends the opportunity of capital growth.

To summarise, single-digit returns for traditional asset classes should be seen as a return to normal for a low inflation world.

On a pre-tax-and-fee basis a traditional 60/40 growth/income balanced fund might return 2-3% pa less than over the past 10 years.

This scenario may understandably lead investors to search for higher returns.

In this environment direct property deserves consideration. The New Zealand property market is better placed today than it has been for many years with both Wellington and Auckland CBD office markets picking up and the retail and industrial sectors performing strongly.

Looking to the future, balanced fund portfolio managers are likely to increasingly seek property exposure via a mix of local and global assets.

Moreover, enhanced performance by fund managers holding property should continue to be sought by holding both direct and listed property assets and varying the allocation through the property cycle.

Steve O'Malley is a property research analyst with AMP Henderson Global Investors

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