Brian Gaynor: Property syndicates not for faint of heart

Once again a large number of deadly minefields are being laid for New Zealand investors.

This time it is property syndicates, also known as proportional title syndicates.

These schemes, which have proliferated in recent months, are illiquid, offer unrealistic returns and will probably lead to large capital losses for investors.

They are not too dissimilar to the disastrous securitised property products developed by Wall St that are the foundation of the current economic crisis.

Nevertheless income-starved New Zealand investors are attracted to these syndicates because the promotional material contains a picture of a property and the numbers "9.5 per cent" or "10 per cent".

These numbers refer to the cash return per annum but there is usually an asterisk warning that this is the projected return for one year only.

Most syndicates have no termination date, annual returns may fall after the first year and it is the promoters, rather than the investors, who get rich from these schemes.

Each of these offerings should carry the clear warning that "property syndicates are a major danger to your financial wellbeing".

Proportional title syndicates are created under the Securities Act (Real Property Proportionate Ownership Schemes) Exemption Notice 2002. Under this legislation promoters have to issue an "Offeror Statement" rather than a prospectus and investment statement.

The "Offeror Statement" is much more difficult to obtain than a prospectus because it does not have to be registered at the Companies Office.

Promoters use flyers and newspaper ads to entice investors but there is rarely an "Offeror Statement" available on their websites and interested parties have to fill out an application form with contact details.

The cynic would argue that these contact details allow the promoters to put direct pressure on potential purchasers and to avoid sending the "Offeror Statement" to parties that would be inclined to criticise the proposition.

Investors in these syndicates don't own separate parts of the property, they each own a share of the whole property.

There has been a massive increase in property syndicate offerings in the past few months as existing owners have realised that syndicates will pay higher prices for property and investors are attracted by the 9.5 per cent to 10.0 per cent yields.

Among the parties that have brought offerings to the public are CB Richard Ellis, Commercial Investment Properties (a Timaru-based company), Augusta Funds Management, Bayleys, Hamilton-based Oyster Property Group, St Laurence, Colliers International, Century 21 and the Christchurch based Suncorp Australasia and Ocean Partners.

One of the more aggressively promoted syndicates at present is the property at 510 Mt Wellington Highway, Auckland.

This industrial property, which is owned by St Laurence Property & Finance, was valued at $23.1 million on March 31, 2008. St Laurence's 2008 annual report noted that "construction of a new office warehouse is now well under way on this property to accommodate a new tenant, Express Data New Zealand".

Annual contracted rental of $2.2 million at present is made up as follows:

Private equity-owned Repco $1.4 million with the lease expiring in 2015.

Express Data $0.5 million with lease expiry in 2016.

McConnell Dowell $0.2 million with the lease expiring in 2012.

Shell $0.1 million with lease expiry in 2013.

DTZ values the property at $25.7 million and it is being sold to the syndicate for $25.5 million. It is difficult to know if this is a fair price but syndicates are paying more for properties than traditional buyers.

The reason for this is that a sale to a syndicate is more risky, as far as the vendor is concerned, because it is conditional on the public raising being successful whereas sales to traditional buyers do not have this condition.

The total cost of the building is $26.4 million, not $25.5 million, because of a number of additional costs. These include an offeror's fee of $446,000 paid to Augusta Fund Management and a brokerage fee of $271,000 paid to Baileys. The most important aspects of these syndicates are gearing, rental income and interest costs.

The attached table is a simple attempt to show how syndicates gear up in order to maximise returns, at least in the first year, and how changes to the variables can dramatically impact on returns.

Column 3 is the proposed structure for 510 Mt Wellington Highway and is based on the following assumptions:

The property will be 41 per cent geared with $15.5 million of equity and $10.9 million of debt.

310 shares will be issued at $50,000 each.

Rental income will be $2.2 million.

Interest costs will be $610,000, based on the forecast interest rate of 5.6 per cent.

Based on these assumptions the return on each $50,000 share will be $5000 or 10 per cent before depreciation and tax. Investors are responsible for tax but can deduct their share of depreciation.

Columns 1 and 2 show that the projected returns are lower if the property is less highly geared. Column 4 illustrates that the projected returns drop sharply if the McConnell Dowell space becomes vacant and interest rates increase to 10 per cent.

Thus the "10 per cent cash return" banner that is draped across all the syndicates' advertising is conjecture, particularly after the first year, and the actual return may be much lower than this. Most syndicates also have no termination date and no market for the shares. Investors can be locked in for years and, if the scenario outlined in column 4 of the table develops, it would be extremely difficult for them to recover their investment.

There is also no alignment of interests between investors and the manager, Augusta Fund Management.

Augusta will be paid $55,000 per annum from July 1, 2010 and this will be increased annually by the rate of inflation.

This fee, which is in addition to all the costs incurred by Augusta in managing the property, will encourage the manager to keep the syndicate going as long as possible.

It is difficult to understand why anyone would invest in 510 Mt Wellington, particularly when it is compared with the six largest NZX-listed property entities.

The poorly performing Kermadec Property, which is also managed by Augusta, is not included in this comparison.

The listed vehicles, which are PIE compliant, offer the following features:

The average gross yield for investors on the top marginal tax rate of 38 per cent is estimated to be 14.0 per cent for the 2010 year compared with a projected 10.0 per cent for 510 Mt Wellington.

The listed entities have widely diversified portfolios and a liquid market for their securities whereas most syndicates have just one property and there is no market for the shares.

Most listed property companies are selling well below their net asset value (NAV) whereas 510 Mt Wellington is being sold above NAV when establishment costs are considered.

The gearing ratios of all six major listed property stocks are projected to be below 40 per cent next year, with an average of 33.5 per cent compared with 41 per cent for 510 Mt Wellington.

Property syndicates are not investor friendly, they have poor corporate governance structures, they are particularly risky, have no termination date and there is no market for their shares.

By contrast listed property companies offer higher gross yields, have diversified portfolios and lower gearing, are more transparent and there is a liquid market for their securities.

For astute investors, who want an exposure to property, NZX-listed entities are far more attractive propositions than property syndicates.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.