Brent Sheather: Running the ruler over property stocks

The listed property sector of the world's sharemarkets is riding on a huge wave of investor optimism at present.

Listed REIT (real estate investment trusts) stocks in just about every market except for the United Kingdom are trading at premiums to their independently valued property assets.

In the United States, UK, Europe, Australia and New Zealand, property stocks have delivered double digit returns, with securitised property in most countries soundly outperforming the broader indices. But it hasn't always been plain sailing for stock exchange-listed property companies.

Not so long ago, in the late 80s and early 90s, in Australia and New Zealand, listed property securities were popularly despised as somehow combining the returns of bonds with the risk profile of shares. Unlisted property unit trusts, whose valuations were determined annually by registered valuers, were the favoured instrument to obtain exposure to property.

Mum and dad were warned that these unlisted property funds really were property but, if they were to be listed on the sharemarket, watch out - in some nightmare scenario, the property suddenly morphs into risky shares and, at the first sign of trouble, all is lost.

Despite the silliness of this argument, the jury was out for a good while; no matter that much of the criticism of REITs came from the promoters of unlisted property funds and their financial planner confederates.

A verdict was duly reached when mum and dad's stockbroker suggested they test the exotic valuations of the unlisted funds by cashing in their units. The music suddenly stopped as the underlying property backing the unit valuations could not be sold at anywhere near the prices claimed. The rush to exit became a stampede and redemptions were suspended.

It's a sad story but one worth retelling. The position of mum and dad unlisted property investor who didn't panic and sell was made considerably worse by those who managed to get out at overvalued prices.

Usually when investors panic and sell, they are the authors of their own misfortune. Not so with the unlisted property market. A hypothetical example illustrates the nature of the tragedy and how many mums and dads lost everything despite investing in blue-chip bricks and mortar: The XYZ Prime Property fund owns a range of CBD Sydney office buildings with a market value of $500 million but, perhaps due to pressure from the managers of the fund (who know that the better they perform the more money will flow into their fund), it is revalued to $600 million.

There are 600 million units on issue and they can theoretically be redeemed by investors for $1 in cash a unit at any time. The valuation of the portfolio is done annually in March. Between the valuation last March and February, interest rates rise and property prices fall by 10 per cent. The XYZ portfolio can now only be sold for $450 million, if indeed buyers can be found. The unit price, however, stays at $1 as the fund is not due to be revalued for another month - in March. Between March and February, some unit holders become nervous and 50 million units are redeemed at $1 that the property managers, not wanting to sell property at low prices thereby putting pressure on their other optimistic valuations, fund by borrowing.

It is clear in the real property market that prices are heading southwards but, due to the infrequent valuations of the XYZ portfolio, this reality will not be reflected in a lower unit price until March. There was a huge arbitrage opportunity if hedge funds had been around in the late 80s; the XYZ fund would have been a great short.

In early March, the rush for the exit begins in earnest and, before redemptions are finally suspended, another 50 million units are paid out at the $1 price, again funded with debt. Across Australia, unlisted funds are freezing redemptions.

Investors can't sell out; not even to pay for the groceries. The March valuation is eagerly anticipated by investors and the media. The trustee of the XYZ fund, wide awake now after two years of slumber, decides that a new valuer might be a good idea.

This is not altogether surprising as property valuers are being criticised almost daily in the business newspapers as being out of touch with reality. The new property valuer decides to be conservative and opts for higher capitalisation rates, lower rates of rental growth and duly arrives at a value of $400 million for the portfolio.

After all this bad publicity, virtually every unit holder in the XYZ fund wants to get out but the real property market is illiquid. It takes almost two years to sell out the underlying properties and total proceeds after costs are only $280 million, less $100 million in debt leaves $180 million or 36c a unit for the 500 million units remaining on issue. Mum and dad, who bought in at $1.05 (including 5 per cent commission), sell out after two years at 36c, a loss of 69c a unit.

Well that was the early 1990s. It couldn't happen today. Maybe not in New Zealand, maybe not in Australia but it has just happened again and on a much bigger scale in Germany.

The Financial Times reports that millions of Germans may have been mis-sold open-ended property funds in recent years because valuers have over-estimated the true worth of the underlying real estate. In 2004, the fund management arm of Germany's public sector banks had to bail out its €6 billion ($10.4 billion) property fund by injecting €2.2 billion of new equity and, in December 2005, Deutsche Bank suspended redemptions from its €6 billion fund freezing the savings of some 300,000 mums and dads. Another fund suspended redemptions in late February.

The lessons from the German and local experience are clear: in the real world, property is volatile - prices go up and down just like the value of all other businesses. Property valuations are, ultimately, decided in the bond and equities markets - a function of interest rates, inflation expectations and risk.

A sharemarket that connects property values to bond yields and risk premiums, and which provides liquidity and permits continuous pricing, is the best protection naive investors have from all manner of sharp practice, bad management and adverse markets.

The crash of the Australasian unlisted property market and the subsequent resurrection of listed REIT stocks was not without its share of ironies. Back in the early 90s, the unlisted funds were criticised as using wildly optimistic capitalisation rates - yet overseas today capitalisation rates of around 5 per cent are common in the sharemarket valuations of the listed companies.

* Brent Sheather is a Whakatane-based investment adviser.