Misvalued and Overleveraged: Where Property Fund Investors Go Wrong

There have been billions lost to failed property investments in the past.

Australians might recall the rise and fall of Alan Bond, with property behind his initial success and overleveraging behind his later bankruptcy. Or Christopher Skase’s Qintex, which owned a number of resorts, and hit hard times in the late 80s (this aside from other fraudulent activity).

In recent years, funding high-risk property developments was just an aspect of the failures of the Shield Master Fund and First Guardian Master Fund, while Dixon Advisory and Superannuation Services entered voluntary administration after being found to have breached the Corporations Act when it advised clients to invest in the US Masters Residential Fund despite it being unsuitable.

In the last year alone, ASIC announced an investigation into the Lion Property Group for financial misappropriation, while property and business investment company ISG Funds Management had been trading while insolvent and has left investors with losses of $145 million.

It’s enough to scare even the hardiest of investors away from property, but that would mean missing out on the potential benefits that can come from legitimate funds managers in this asset class.

After all, managed property funds can offer a regular and consistent income stream via rental returns, diversification, exposure to growth in the property market, along with access to different sectors within the property space, such as commercial and industrial properties.

While bad players will always exist, there are a range of ways investors can aim to better protect themselves when investing in property funds.

Failure 1: Overvaluation of assets

A common issue in failed property funds is when the underlying assets have been overvalued so that in the event that the fund had to sell the asset, it would be for less than what has been paid for it.

Ideally, property managers should conduct regular valuations of the assets (ideally more than annually) and have specialist experience in managing or developing property. They should publish this information regularly too. For example, the Dexus Australian Property Fund discusses changes in valuations in parts of the portfolio in its quarterly updates.

Look for long-established management track records and transparency in asset information, such as sharing cap rates, rental growth assumptions and vacancy rates.

Some fund managers might also use independent valuations of the properties they hold on their books too.

An alternative way of managing this would be to consider funds with listed properties (REITs) instead which move with the market and are easier to sell compared with direct property funds. Some examples include the SPDR S&P/ASX 200 Listed Property ETF or the Pengana High Conviction Property Securities Fund.

Failure 2: Leveraging

Both Bond and Skase were famously overleveraged. This hit hard when rates started to rise in the late 1980s. The combination of overleveraging and overvaluation was the issue in the subprime crisis of the GFC.

You should factor leveraging in managed property funds too. Consider how leveraged the underlying properties are and the ability to repay debts, particularly if interest rates rise.

The term to look for in fund documents is the Loan-to-Value (LVR) ratio – a higher ratio is a higher risk of loss, though some funds might refer to gearing instead to represent loans or debt.

If you take a basic example in terms of how banks might look at LVRs, usually banks will treat an LVR of above 80% as high risk, but you’ll find that some property managers might take a more conservative approach depending on the sector of property they invest in.

For example, the CP Income Opportunity Fund has a target-weighted average LVR of 75%, the Trilogy Industrial Property Trust has a target LVR of 50-60% and the Centuria Healthcare Property Fund has target look-through gearing between 35-45%.

While leveraging can be a specific part of an investment strategy, investors can also consider looking for property funds that have low leveraging or are ungeared/unleveraged (no debt) to avoid this concern. Using funds and ETFs that invest in listed securities and REITs, such as Resolution Capital Global Property Securities Active ETF (ASX: RCAP), is one approach because these are unleveraged strategies – the underlying securities may have some degree of leveraging within them but the fund itself isn’t geared and investments are diversified across many securities.

Failure 3: Liquidity

As a physical asset, property is not necessarily easy to sell and this can affect an investor’s ability to access their funds if they need them.

Some direct property funds will have withdrawal restrictions or not allow redemptions until the completion of a development. Investors should check the product disclosures or investment memoranda to understand this before investing.

For example, the CFMG Land and Opportunity Fund has an investment term of 20-36 months and investors cannot make withdrawals prior to the end of the term or the MPG Hardware Trust has a limited withdrawal facility where there is liquidity in the fund, but otherwise has a defined exit with the term ending 30 June 2026.

Listed property securities are typically the most liquid investment options so investors who need liquidity may be better suited to funds using these.

Failure 4: Property market movements

Australians may be accustomed to viewing property as an asset that only grows, but it does fluctuate and can experience falls that will affect the value. Different sectors can fluctuate at different points too.

For example, during and immediately after the COVID pandemic, the office sector was challenged and fell in value due to workers becoming accustomed to work-from-home arrangements. As this has shifted, the office sector has recovered.

Even if you look at residential property, movements are not necessarily universal. Certain regions outperform others. Certain types of property outperform.

This is all something to factor in when you select a property investment, particularly if you choose a targeted property investment focused on a sector like childcare, industrials or residential property.

Managing this risk comes back to a few things.

Quality of the underlying assets is important – for example, if a fund invests in offices, then check that the offices are well maintained, in desirable locations for workers and typically have low vacancy rates. High quality properties are better able to manage market movements, and have a better likelihood of recovery, or better ability to be sold if necessary.

You can’t skip diversification either in property funds – whether it is a fund investing in direct property or in REITs, check that these are spread across regions and sectors. If you choose a fund that specialises in just one sector, then aim for it to be diversified in other ways, such as location.

Offsetting the risks

Property can be an effective investment in a diversified portfolio, but as a less liquid asset, it pays to take the time to research what you are really getting. If you were to start your research with just a couple of focus areas to narrow your field down, keep in mind quality of the assets, lower debt levels for the funds and the expertise of the fund manager.

Finally, keeping in mind the fund collapses like First Guardian and Shield Master funds, always check that you are investing with a fund manager with a current Australian Financial Services Licence (AFS) from ASIC and they are allowed to offer investments in Australia. You can start with Moneysmart and the ASIC website to check if there are any concerns over a fund or fund manager.

Funds Mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.