Daily Equity Report
Seed Weekly - Property ? Return Deconstruction
Many successful investors look to invest into assets that offer an attractive initial yield with a high probability of that yield growing consistently in real terms into perpetuity. By taking this approach, investors need not overly concern themselves with the prospects of capital growth, as the income generated (that should be consistently reinvested) will be a large component of the total return and, as with most investments, capital growth should approximate income growth over a full cycle. Furthermore, if investing when the yield is higher than the long term average, investors could receive additional capital returns through the rerating of the asset.
Investment returns can therefore be broken down into 3 broad sources:
• Initial yield
• Growth in yield
• Change in rating
When looking at the local listed property market, it is interesting to dissect the three sources of return to determine whether this asset class offers value or not. Property is an asset class that local asset managers have (even in their own words) historically been underweight, and it is interesting that there are currently divergent views about this asset class amongst some of the larger managers.
The starting yield offered by this asset class is currently 5.3%, which is at the low end when compared to its history. This is partially offset by ultra low interest and inflation rates which have resulted in most other asset classes also offering historically low yields. While the market trades at historically low rates, property portfolios can be constructed with an initial yield of between 6.7% - 7.7% (above cash and broadly in line with bonds).
While it’s all good and well to construct a portfolio with a high starting yield, it is short sighted if this is done at the expense of yield growth. The above mentioned portfolios have expected annual distribution growth over the next three years of between 8.5% and 10.5%, which in the current low inflation environment is healthy real growth. These expected numbers aren’t much different from the historical real growth in yield generated by property. The chart below shows real distribution growth of the index over the past 10 years. Over this period property distributions have grown, on average, 2% pa ahead of inflation (in line with the often quoted 8% annual rental escalation clauses many tenants face). Even from their peak (in mid 2007) distributions have grown in line with inflation.
Naturally there are risks that real distribution growth will temporarily go negative, which is where active management will play an important role. Over time, however, we remain convinced that the industry as a whole can grow distributions in line with inflation, with the better operators growing income in real terms. We also think that investors under appreciate (and hence undervalue) the consistency of this distribution growth (over this period annual equity distributions have twice contracted by more than 10% in nominal terms).
Over the very long term the impact of the change in rating doesn’t have too much of an effect on the total return generated from an investment (unless investing at valuation extremes). It does, however, add to the volatility of the return over the shorter period and is often a reason used by investors not to invest into property. This is the case as the initial yield has a high correlation with the bond yield, but what investors often fail to appreciate is the consistent growth in yield from property that is nonexistent in bonds. We also don’t define risk as volatility, but rather the permanent destruction of capital.
Seed’s Multi Asset Funds (Seed Flexible Fund and Seed Absolute Return Fund) and other managed solutions have performed extremely well over the past few years on a back of a sizeable allocation to property. While we aren’t married to this investment view, we expect that property will continue to deliver solid mid to upper single digit real returns for the foreseeable future (although it may exhibit a fair amount of volatility on the way).
Tue, 24 Mar 2015- 09:40
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