Property syndicates dwindle as they fail to deliver good returns

Friday 14th December 2001

New Zealand property syndication offerings seem to have dwindled recently.

I was reminded about them when I received an email from Australia advertising a new one over there. Out of curiosity I applied for a prospectus online, only to be informed that the offering was for Australian residents only.

After that a letter arrived from the syndicator urging me to invest without delay - when I had not even got the prospectus requested. I inferred that they might be having trouble filling the issue and that their administration systems needed a tidy up.

That the letter was signed by a person called Bridget Risk did not help.

Property syndications have had a chequered history in New Zealand. Quite a number have had difficulty paying satisfactory returns to investors.

Rent received from tenants has to fund not only investor payments but also taxes, levies, bank debt, building maintenance, property management fees and whatever else besides. The latter costs to investors can reduce payout yields to the level of bank deposits or lower.

Syndicates need to beat the bank if they are to attract or retain investors.

Many syndicates were premised on beating the bank on future rent increases that have not since materialised. Others have used tax-efficient structures that convert part of the investment into a loan to the syndicate so rent can be paid out as capital, boosting hypothetical tax-paid equivalent returns.

A core consideration for the investor is sustainability of return because property syndicates represent illiquid, buy-and-hold assets. Close attention to the investment statement is needed to check how reliable future income will be.

The rental yield should be compared with the yield to the investor to establish what difference arises between the two and why. Management fees and other costs, as well as tax deductions, should be assessed as a net percentage of the rental yield.

The remaining percentage of yield is where investor returns will come from. One way for syndicators to boost apparent returns is to require as part of the investment provision a capital pool on top of the purchase of the building.

This pool can then be repaid progressively to investors as a top-up of their portion of the rental yield. They are getting their own money back, in other words, and when the capital runs out they are exposed to the risk that the rental on the property will not increase enough to sustain at least the same level of payment.

It can be worked out from analysing the amount of rental that investors actually receive how much of a top-up is needed from capital and when that capital is exhausted. Exhaustion point is crunch time for the syndicate.

Syndicators try various ways to repair the damage. In theory they could sell the buildings and return the proceeds to investors but in practice they would lose their management fees, so that resort is rarely seen. Instead they might amalgamate syndicates or place more properties in them, requiring further investment from the public.

There can be something of a Ponzi scheme about some of these arrangements, especially if the same problems recur in future.

Exiting property syndicates that are not performing is not always straightforward. Syndicators usually offer a secondary market.

But if a syndicate has problems paying then investment in it will sell at a discount - assuming it can be sold at all - meaning a capital loss to the investor.

The veracity of quoted prices on secondary markets needs close attention as well. If these prices are not genuinely open market value, then they could be subject to manipulation and arbitrary or unrealistic valuation.

For one matter, initial setup costs and brokerage fees should be subtracted from the subscription price as unrecoverable costs to the investor.

The result is that on day one of posting on the secondary market the investment is actually worth less than was paid for it. The syndicate then has to make up for that loss of value to bring the investor back to square again.

Also, where loan structures of finite terms are involved, the secondary market price should accurately represent the discounted present value of the loan.

Hybrid structures of a real estate holding and a fixed-interest loan require careful attention to pricing because of different valuation procedures.

There is a risk of fraud or negligence being perpetrated on buyers or sellers where secondary market prices are inaccurate.

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