Commercial property, whether held directly or in a listed or unlisted trust, can make an attractive addition to a balanced investment portfolio. Quality office property offers investors a regular, often tax-advantaged, income stream, and because commercial leases are frequently inflation-linked, it can be a good hedge against inflation as well. In addition, there is the potential for capital upside. Property has traditionally (although not without exception) been de-correlated from equity and fixed interest markets, meaning it can provide diversification benefits and smooth out returns from a portfolio over time.  

Listed property trusts, or Australian real estate investment trusts (A-REITs), are a form of joint ownership, in which investors’ pool their money together to buy either a single property, or more typically, a portfolio of properties. Investors purchase units in the trust and the trust is listed on the Australian Stock Exchange (ASX). This means that investors can buy and sell units in the same way they might buy equities, making A-REITs an appealing option for investors looking for commercial property exposure, but with the liquidity that comes from listing on an exchange. 

In essence, A-REITs give investors access to commercial property portfolios for a fraction of the cost of buying a property directly, without tying up funds, and with the added benefit of being able to increase and/or decrease exposure easily.

A-REITs can differ significantly

A-REITs vary, both in terms of portfolio and investment strategy. Some are sector-based, in that they invest only in one sector of the property market – for example retail, office, industrial, hotel, or healthcare. Others have a more diverse portfolio, with a mix of properties from different sectors, and still others focus on other specialisations, such as location – e.g. metro versus CBD or prime versus secondary assets. According to Deloitte as at the end of 2017, retail A-REITs made up 45% of the market capitalisation of the sector in Australia, office 12%, industrial 12%, diversified 27% and alternatives 4%. However, a closer look at the composition of the diversified A-REITs reveals that they are largely weighted to the office and retail sectors, making the actual exposure of the market to these sectors higher. 

Investment strategies also vary from trust to trust. Some A-REITs are rental-income focused, meaning their primary aim is to maximise rental income from their portfolio of properties and to distribute as high a proportion as is prudent, in the form of income to their investors. Others may retain a higher percentage of rental and other income, and distribute a lower percentage of gross income, for a variety of reasons, including undertaking of funds management and property development within the trust. The manager of the trust should make the strategy of the trust clear to investors.    

Because they are listed, A-REIT unit prices can be influenced by general market movements, in addition to investors’ and the market view of the underlying property portfolio. This means that general economic data – some of which may not be directly tied to specific property performance or price, at least in the short-term – can affect the unit price of A-REITs.

In this respect, they are a less ‘direct’ investment in commercial property than an unlisted property trust. Property valuations in unlisted trusts are typically performed only once a year and therefore the unit price does not move up and down daily in the way that it can in an A-REIT. 

Key changes in the sector over time

A-REITs have been a part of the listed market for many years, however, their structures and some of their fundamental metrics have changed significantly over time – we believe for the better. 

The following table shows some of the key differences and gives some of the reasons for the change. 

Listed property trusts: then and now

Feature

2007

2018

Payout ratio

95%

82%

Offshore assets

40%

21%

Gearing levels

40% +

26%

Funding tenure

Shorter term

Longer term

Let’s describe each feature:

1. Payout ratio

The payout ratio describes the percentage of returns distributed to investors. This will vary depending on the REIT’s investment strategy. 

A-REITs that are straight rent collecting vehicles – such as the Centuria Metropolitan REIT (CMA) and the Centuria Industrial REIT (CIP) – will generally distribute a high percentage of their income, while keeping aside some funds for maintenance, improvements and unexpected costs. These A-REITs have simple structures and a simple purpose – to distribute rental returns from tenants to investors. 

Some A-REIT’s retain the funds management and property development functions within the entity. There are a number of reasons for this – in general linked to the size of the portfolio or any specialised aims it might have.  

In general, a development-focused A-REIT has a lower payout ratio, because property development requires significant capital and returns can be lumpy. This means keeping back a larger percentage of earnings to fund the development or smooth out returns. 

2. Offshore assets 

Offshore assets refer to the percentage of offshore property assets held in the trust. 

In general terms, a more diversified portfolio is likely to be less risky than a highly concentrated one, and in this respect, offshore exposure could be seen as offering diversification benefits. However, given the risks associated with investing in physical assets offshore, a high level of offshore assets in a portfolio (40% plus in 2007) will typically be a riskier strategy than keeping offshore assets at a more conservative level. 

This was demonstrated clearly in the lead up to the GFC, when managers were tempted overseas because property values compared favourably with a hot market at home – yields were higher, which meant balance sheets looked better, and earnings per unit were higher. 

When the GFC hit however, and property markets turned, some A-REITs struggled to sell their assets, not only because the market itself was more difficult, but because they had the added burden of negotiating a different regulatory environment, without the market knowledge and relationships they had at home. 

These days, overseas assets make up on average 21% of A-REIT portfolios, and the bulk of the exposure comes from two major players – Westfield, which owns shopping centres in the United States and the United Kingdom, and the Goodman Group, which owns industrial property in Asia. Both of these groups are world-class investors in each of those asset classes.

3. Gearing levels 

Gearing levels refers to the amount of debt in the trust. In 2007, interest rates were higher and there was a significant gap between the cost of long-term financing (very expensive) and short-term financing (much cheaper). This created problems for some trusts, which used short-term funding to pay for acquisitions, and then sought to arbitrage the difference between the funding cost of a property and its yield. When credit markets changed, some found it difficult to close the gap, resulting in poor performance for investors.

4. Funding costs 

Funding costs are lower today than in 2007, and gearing levels much more conservative – 26% on average. 

Funding tenure is also now longer. Funding sources are more diverse than in the past, and on average, most trusts have longer funding terms, which usually means better quality, more conservative debt.

Quality commercial property can be an attractive addition to an investment portfolio, but if, like most investors, you don’t have the funds to purchase an entire commercial building at your fingertips, pooling your money with others can be a good option. Listed and unlisted structures both have pros and cons. Unlisted property trusts arguably offer a more direct exposure to commercial property, in that the underlying property portfolio is usually valued once a year and unit prices do not move up and down with market movements in the same way listed investments do. But at the same time, most unlisted property trusts will require you to lock up your money for between 5-7 years. 

A-REITs, on the other hand, are listed and therefore liquid, and allow for you to move your commercial property exposure up and down. Structurally, they are more conservative now than they have been in the past, in terms of gearing, percentage of profits distributed, and number and value of offshore assets in the portfolio, all of which is positive for risk-averse investors. The flipside of being listed, however, is that unit prices can move in line with general market sentiment and are not as closely tied to property fundamentals.

However, it’s most important to understand that whether you are considering an A-REIT or an unlisted trust, all investments carry risk. The best way to understand and mitigate this risk is to look carefully not just at the underlying portfolio of a trust, but at the experience and quality of the manager, including investment strategy. Make sure you obtain the relevant offer documentation, consider it carefully, and think about seeking advice from a professional investment adviser if you have any questions.