By David Bassanese

Given the Reserve Bank of Australia’s latest cut in official interest rates, the so-called “search for yield” across the equity market is likely to remains alive and well for some time. 

That said, with outright price to earnings share market valuations reaching relatively high levels of late, there’s understandable concern that this quest for yield is at risk of going too far.

So just how inflated have income-generating listed equity prices become? And are there any alternatives?  

Let’s focus on listed property. According to Thomson Reuters estimates, the price to forward earnings ratio for the S&P/ASX 300 A-REITs sector ended April at 15.9 – compared with an average since late 2002 (ignoring the distorted valuations during the GFC period from Jan-2008 to Jun-2010) of 14.2. The sector’s dividend yield is down to 3.6% from an average of 5.3% over the same historic period.

In outright terms, therefore, listed property is clearly expensive on historic grounds. 

But here’s where it gets tricky. Relative to interest rates, listed property still appears cheap. 

After all, the yield on Australian 10-year Federal Government bonds ended April at 2.7% - compared with an average of 4.8% since 2002 (as above. excluding the GFC period). The average gap between the listed property dividend yield and the bond yield has been around 0.5% over this period – but as at end-April, it was still at the high end of its range, at around 1%.  

Using another metric, the gap between listed property’s forward earnings yield and the bond yield ended April at 3.6%, compared with the long-run average of 2.4%.

So provided bonds yields stay low – which seems likely as the RBA retains an easing policy bias – the search for yield locally may well continue. 

Of course, one risk is if bond yields globally take-off due to the looming start of policy tightening in the United States. But limiting this risk is the fact that global inflation remains low, the Fed is likely to remain very cautious, and other central banks – notably in Japan and Europe – are still printing cash.

That said, if investors are worried about potential bubble conditions developing in the listed property sector – and a hard landing – another option worth exploring is the unlisted property sector. As seen in the chart below – courtesy of Mercer Consulting – returns in the unlisted segment of the commercial property market tend to be far less volatile, largely because asset valuations occur less often, whereas listed property valuations are effectively re-priced daily. 

Valuation in the listed sector, moreover, are governed (in the short-term at least) by investor sentiment, which can lead to occasional severe mispricing to both the upside and downside relative to unlisted assets. Of course, valuations in the unlisted sector can also lag fair-value for a time, but the eventual revaluations at least tend to be more fundamentally driven. Values in the unlisted sector, for example, did decline during the GFC, but by much less than in the more temperamental listed property sector.

According to Mercer’s indices, over the past year returns in the listed sector have again shot ahead of the unlisted sector, though this always tends to be the case when equity markets are enjoying a good bull run. From a long-term investor’s perspective, however, what’s important to appreciate is that the returns in both sectors have tended to be similar over time, as the table below suggests. 

 

 

Listed vs. Unlisted Asset Returns

Source: Mercer Consulting

Of course, the one downside of some unlisted funds is that your money may need to be tied up for a number of years – whereas in the listed sector you are free to cash out at anytime. That, however, can be a mixed blessing, especially if the ease of selling causes investors to sell-up at precisely the wrong time when panic levels are high. 

Based on the fact they produce similar long-run returns, the greater “illiquidity” of unlisted property funds seems to be offset in investor eyes by the reduced year-to-year volatility in returns. Industry super funds in particular seem to love unlisted assets – many of which they access directly (through buying chunks of airports and toll roads) because of comparable long-run returns to listed property funds while at the same time offering reduced return volatility.  

The upside, moreover, is that income returns in the unlisted sector tend to be higher and less volatile – which should be especially appealing for those seeking income. 

All up, if you fear returns in the listed property sector have run too hard but you’re still seeking decent income returns for limited risk and volatility – a look over the unlisted property fund universe may be worth the effort. But in doing so, accept you may need to tie your money up for a few years – in which case you need to have a lot of confidence in the management running the fund.