Why Institutional Investors avoid Residential Property

One of the misconceptions investors have is that the $123 billion dollar listed property index is primarily exposed to residential real estate. In fact, residential property comprises a small part of the index, with only 4% of the value of the index coming from trusts exposed to residential property. Further, this exposure primarily comes from developers selling finished apartments or home and land packages, not from actually owning housing real estate that is rented out.








Last month Mirvac announced they will be bringing Australia’s first major build-to-rent apartment development to market in a move that could potentially address housing affordability issues. In this week’s piece, we will look at why institutional investors have shied away from investing in residential developments, unlike in the US and the UK where this sector is a growing part of the Listed Property indices.

Residential property has attracted little interest from institutional investors as it is an area where retail investors have an investment edge. In the below chart, the grey bars show that exposure to residential real estate comprised 4% of the S&P/ASX 200 A-REIT index in September 2017, or $4.7 billion. This is dwarfed by the value of the discretionary retail ($59 billion), industrial ($25 billion), and office ($22 billion) real estate assets listed on the ASX. In comparison in the US, the residential sector accounts for around 25% of the $US2 trillion in institutional property investment, placing the sector just behind office.


Whilst the smaller transaction size of buying a two-bedroom apartment is attractive to retail investors (compared to an industrial warehouse or an office tower which may be valued in the tens to hundreds of millions), there are three structural reasons why retail investors dominate residential property investment.

Capital gains tax “crowds out” corporate investors

Although the domestic rental sector exists  in LPTs in the US and Europe, in Australia the tax-free status of capital gains for owner-occupiers selling their primary dwelling has had the effect of bidding up the purchase prices of residential real estate. For example, when a company generates a $500,000 capital gain from selling an apartment, they would approximately be liable to pay approximately $108,000 in capital gains tax, whereas the owner-occupier pays no tax on the capital gains made on a similar investment. This discrepancy in the tax treatment allows the owner-occupier to pay more for the same real estate assets, and thus has contributed to the low yields mentioned below.

Negative gearing

Similarly, individual retail investors benefit from the generous tax treatment in Australia that allows them to negatively gear properties. There are three types of gearing depending on the income earned from an investment property: positive, neutral and negative. A property is negatively geared when the rental return is less than the interest repayments and outgoings, placing the investor in a position of losing income on an annual basis. However, under Australian tax law, investors can offset the cost of owning the property (including the interest paid on a loan) against other assessable income. This incentivises individual high-taxpaying investors to buy a property at a price where it is cash flow negative in order to maximise their near-term tax returns and bet on capital gains. Whilst companies and property trusts can also access taxation benefits from borrowing to buy real estate assets, a rich doctor on a top marginal tax rate of 47% has a stronger incentive to raise their paddle at an auction.

Yields on residential property too low

At current prices, the yield that residential property offers are not very attractive for listed vehicles. At the moment, the ASX 200 A-REIT index offers an average yield of 5%. This compares very favourably with the yields from investing in residential property. SQM Research reported recently that the implied gross rental yield for a 3-bedroom house in Sydney of 3% with a 2-bedroom apartment yielding  4% in July 2017. After borrowing costs, council rates, insurance, and maintenance capex, the net yield is estimated to average around 1%. With listed property investors focused on yield receiving on average ~ 5% from property trusts investing in office towers and shopping centres, such a low yield would only be accepted if it was offset by high and certain capital gains.
Mirvac’s new “build to rent” fund

In August Mirvac announced their intention to develop a build to rent fund with assets based initially in Sydney. This fund is likely to be targeted at institutional investor, rather than retail investors, who generally already have a significant exposure to residential real estate. This looks to be an opportunity for Mirvac to access both development profit (profit margin +25% in FY17) and also an ongoing funds management fee on the completed assets. However, we would be surprised to see much of Mirvac’s own capital invested in the fund. In 2017 Mirvac generated a 18% return on the $1.8 billion of capital invested in its residential development business (ROIC). Mathematically it is hard to see how investing in their own finished product will generate returns higher than the trust’s average cost of capital.

Our take

Whilst the residential sector is a large part of the overall stock of Australian real estate assets, without significant taxation concessions it is hard to see this sector garnering much interest from institutional investors, especially for income-focused investors such as Atlas Funds Management. The Atlas High Income Property Fund’s strategy of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should continue outperform in a property market that is trading sideways. We see that the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings, rather than spectacular capital gains.


Monthly Performance May 2017

  • May 2017 marked the launch of the Atlas High Income Property Fund into the turbulent Australian equity market.
  • The Australian Listed Property index fell -1.3% over the month, which was ahead of the wider Australian equity market that declined -2.8%.
  • The Fund’s unit price was essentially unchanged as we are maintaining a cautious approach in constructing the portfolio. Losses were balanced off against gains from call options sold.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in May and the fund’s strategy

What is going on in Listed Property

In this note we will look at what is going on in listed property,  the key themes to emerge over the past month from the profit results and how we expect listed property to perform over the next year. Given the name of our firm it would be remiss not to mention that this week marked the 60th anniversary of the publication of the Ayn Rand novel Atlas Shrugged. This novel provides an examination of whether the pursuit of profit is a noble enterprise or the root of all evil and the conflict in society between thinkers relying on facts and those defying reason, supporting their arguments on feelings.

Since 2012, listed property has been one of the top performing sectors on the ASX 200. During this time, other sectors in the equity market have faced concerns about a rising and then falling AUD, volatility in commodity prices that saw BHP abandon their cherished progressive dividend policy, Eurozone issues, near zero interest rates, and bank capital raisings. Listed property meanwhile seemed to be immune to these destabilising forces.
This all changed in the second half of 2016, when “safe” stocks such as Listed Property Trusts and infrastructure stocks, considered to be alternatives to bonds or term deposits, fell heavily on expectations that global interest rates will start to rise in the future. In the February 2017 results reporting season the management teams of the listed property sector addressed investor concerns about the impact of higher interest rates and their ability to grow distributions in a higher inflation environment. This increased investor confidence and accordingly saw the Listed Property sector gain 7% from the lows reached in November 2016.
As real estate is not a homogeneous asset, it is useful to break down the real estate held by the Listed Property Trusts into four distinct groups: shopping centres (retail), office towers (office), housing and apartment developers (residential), and manufacturing or distribution centres (industrial).
Discretionary retail continues to face the challenges of on-line competition to bricks and mortar, a higher AUD, and slower inbound tourism which has reduced profit margins, particularly in clothing and footwear. Weaker retail sales limit the ability of shopping centre operators such as Scentre and Vicinity to raise rents and typically a rental contract will include a percentage of store sales. New clothing retailers Zara continue to take sales away from department stores like Myer, which is important given department stores are typically the largest rent payer in a shopping centre. Additionally, over the last year shopping centre landlords faced a few tenants closing stores due to insolvency such as Payless Shoes, Howards Storage and Pumpkin Patch.

Whilst the outlook for retail looks difficult, we do not see that shopping centres will become redundant, but they will need to evolve by favouring tenants that offer services that can’t be delivered on-line such as personal grooming and dining.

In contrast to shopping centres, the Australian CBD office market looks pretty healthy for owners of office towers such as Dexus and Investa Office. Vacancy is the best measure of the health of the office sector, as empty floors in an office tower don’t earn rental income for the owners of office property trusts. Overall the market looks stable, but the picture across Australia is quite divergent with vacancy at a 23-year high in Perth being offset by very low vacancies in the Sydney and Melbourne markets.  Sydney and Melbourne have benefited from the conversion of office towers into apartment buildings, which reduces supply, whilst Brisbane and Perth face excess supply from towers built towards the end of the mining boom.

Unsurprisingly the buoyant residential market in Sydney and Melbourne boosted the results of major residential developers Mirvac, Lend Lease and Stockland. Going into the profit results we were concerned that these developers could face defaults from buyers that have paid deposits for apartments (particularly in Melbourne). A buyer may refuse to complete a sale (thus forfeiting their deposit) if after completion the value of the property has declined or the buyer has had trouble obtaining finance. Our concerns were allayed in February with the developers reporting minimal defaults and healthy forward sales.

Although the industrial assets continue to be priced higher, the underlying fundamentals have deteriorated with vacancies rising across the sector. Unlike office towers which are relatively homogeneous assets – which means, for example, that an accounting firm can take over space vacated by a financial planner – industrial sites are often configured for a particular tenant. A great example of this is the challenges the BWP face in filling sites vacated by key tenant Bunnings. The industrial trusts have continued to generate profits from re-zoning industrial property to residential. In October Goodman sold an industrial park in Sydney’s north west for $200 million to apartment developer Meriton Group.

One Year Outlook                                   
The total return (capital growth plus distributions) that investors can expect from Listed Property based on four financial components. These are; 1) distributions, 2) movement in asset values as measured by the capitalisation rate which is the rate of return on a real estate investment property based on the income that the property is expected to generate3) expansions or contractions in the market price to earnings ratio and 4) movement in the number of shares on issue (current buy backs or equity issues).

Over the next year, we see a small increase in the average distribution yield and a slight increase in asset values. However, due to concerns about interest rates it is hard to see an expansion in the market price earnings ratio above its current long term average and there are no significant buy backs currently in operation.  Consequently, it is hard to make the case that the bulk of returns that investors can expect from listed property will not come from distributions.

Our Take

The Property Trust sector as a whole appears to be trading at a premium to fair value. We see that catalysts which propelled the sector up over the last three years have largely been played out and the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings. The sector currently trades at a +26% premium to net tangible assets (14.2x forward PE and 5.2% yield).  The portfolio strategy of the Atlas High Income Fund of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should outperform in this market. Further, the focus on trusts that are delivering recurring yield should result in a higher distribution yield and lower earnings volatility for our investors.

Hugh Dive CFA
Chief Investment Officer