KEY POINTS:
The credit crisis continues to evolve. The latest manifestation of what started with a repricing of credit risk in the US has seen local unlisted funds investing in long duration, illiquid assets such as mortgages, CDOs and property suffer a sudden loss of investor confidence and suspend redemptions.
What is really surprising is that it took this long to happen, given the structural problems of the vehicles and the weakness in underlying markets.
In most cases the problem of more sellers than buyers has been exacerbated by pricing inefficiencies. In the case of the mortgage trusts the collateral supporting the mortgages - that is, the houses - has gone down in price and investors are simply repricing the mortgages on the basis of lower collateral and higher risk.
So they perceive that the mortgages are worth less due to higher risk and are thus moving to sell to exploit the disparity between the unlisted vehicle, which prices the asset at NAV (net asset value), versus the real market, which says a discount to NAV is more appropriate.
The unlisted pricing mechanism cannot accommodate this change, the price stays at NAV, hence the move to liquidate becomes a rush. In contrast, the bank sector, which is the most visible listed mortgage market, has seen substantial price falls on the basis of the changes in collateral and risk.
If you think about it, mortgage trusts shouldn't trade at a price equivalent to the market value of their mortgages - even in the good times. With a mortgage trust investors don't get the entire coupon of each loan - a 1.5 per cent or thereabouts management fee is usually levied.
Obviously, all things being equal, a mortgage with a 7 per cent coupon should trade at a lower price than one with an 8.5 per cent interest rate.
It's the same with unlisted property companies. They are supposed to trade at valuation but virtually all the listed property companies in New Zealand, Australia and Europe trade at massive discounts to NAV.
In the case of the AMP Property Fund, the move to redeem is likely to have come from institutional investors who perceive that the prices of commercial property in the real world are falling (as evidenced by the low prices of listed property funds), but the unit price of the unlisted funds had yet to fully reflect that fall. This is due to the well documented backward-looking nature of property valuations.
This problem has happened many times before, most recently in Germany, which this column commented on in February 2006. It's also slightly ironic in that many of the assets of the AMP Property Fund were once listed on the New Zealand Stock Exchange under the name of Capital Properties.
History is clear: for informed price discovery, where property capitalisation rates are linked to government bond yields and the stock market's assessment of risk, property needs to be priced via a vehicle listed on the stock exchange. The unlisted structure tries to control supply and demand and price all at once, and this can't be done.
The sharemarket's prime function is price discovery, representing as it does hundreds of thousands of people's views on what each company's dividend streams are worth, discounted to reflect risk and the time value of money. This happens in the same way for all businesses listed on the market.
As Charles Froland says in his classic article "What Determines Capitalisation Rates on Real Estate" in the summer 1987 Journal of Portfolio Management, "the cap rate is the child of the capital markets, just as it should be".
What Froland means is that if interest rates rise or demand falls, the value of a property should decline, for exactly the same reasons as the sharemarket falls. So, far from being illogical, the volatility of listed property is completely rational in that it allows the valuation drivers of the asset to manifest.
An extreme example of the mispricing that arises from valuation smoothing in the unlisted property sector was the great Australian unlisted property trust crash of 1990-1991. Various fund managers, including the odd Fund Manager of the Year, thought they had died and gone to heaven when they discovered that if they continually revalued their properties higher and higher and at the same time suppressed volatility, naive investors would invest more and more money in their funds (which produced more and more management fees).
Unrealistic property valuations weren't a problem when the funds were growing, but the fun ended when a few people advised investors to withdraw funds. At first, redemptions were financed by cash reserves, and then borrowing, but eventually, when there was a stampede for the exit, the funds were suspended and people couldn't sell out.
Because the fund managers let the first people who wanted their money out to exit at unrealistic valuations, there was a leveraged impact on those who stayed in the fund. That is why there has been a mad rush to suspend redemptions.
There is no doubt about it, listed property is more volatile than its unlisted counterpart. But this is the price of a continuous, rather than a discrete, valuation process. This is exactly how it should be. The valuation drivers of property themselves are volatile, but this simply reflects reality.
But in adversity there is often opportunity: the New Zealand Stock Exchange has the infrastructure to operate a secondary market in things like mortgage trusts and the AMP unlisted property fund.
Why not list these products and let those people who need to sell do so, rather than lock the market up and unduly penalise those who have a genuine need for liquidity?
At the same time the managers of the funds could lower their management fees to make them more realistic and knock the trailing fees on the head as well.
New Zealand only has to look at the AIM stockmarket in the UK - the last few years have seen a surge of interest as billions of pounds were raised by listed investment companies focusing on illiquid assets such as property, CDOs, venture capital and hedge funds.
The Capital Market Development Task Force, recently formed by the Government to inject some life into our sharemarket, should be looking at solving the problems of the unlisted vehicles and increasing the depth of the sharemarket at the same time, thereby killing two birds with one stone.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
