Global equity markets staged a recovery in March, though Australia lagged global markets due to falling bond yields and weakness in Chinese equities based on concerns about a stalling recovery in the Middle Kingdom. Domestically the negative impact of a lockdown in Queensland was offset by falls in the unemployment rate and rising house prices.
The Atlas High Income Property Fund had a solid month gaining +3.7%, continuing to recover from the dark days of March 2020, when sections of the media questioned whether we would ever return to offices, shopping centres and toll roads. While most of the listed property sector’s share prices remain below where they were trading in February 2020, the lowly geared rent-collecting trusts that populate the portfolio are in good financial shape, collecting rents and paying distributions.
The Fund declared a quarterly distribution of $0.032 per unit. The distribution will be paid to investors in early April.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2021.
April 2020, many experts predicted that residential real estate was set for a significant correction over the coming year based on expectations of a deep recession and sharp increases in the unemployment rate. Westpac’s economists forecasted an 8% fall in GDP in the coming year, unemployment to reach 10%, and a 20% fall in house prices and, based on this, took a $2 billion provision for expected loan losses.
Instead of falling, house prices accelerated over the past year with the latest CoreLogic RP Data Daily Home Value Index for March 2021 showing a +5.7% increase in national house prices led by Sydney and Brisbane.
As the manager of a listed property fund, Atlas has recently received questions about gaining exposure to rising residential real estate prices without buying a house or apartment. However, as residential real estate is only a tiny portion of the overall listed property index on the ASX, this is an asset class that institutional investors largely ignore. In this week’s piece, we look at why listed property trusts avoid buying houses and apartments.
Listed real estate is not houses
Unlike the US or UK, where residential is a significant component of the listed property index (US residential REIT exposure 18%), the Australian index’s residential real estate exposure is relatively small at only 5% (see below table).
Further, the residual real estate exposure on the ASX consists of the development arms of diversified property trusts such as Stockland (mainly house and land packages) and Mirvac (predominantly apartments). Moreover, neither of these two trusts intends to hold residential property on their balance sheets over the medium term. Greater returns are available from developing and selling residential real estate rather than collecting rents. However, Mirvac has one build-to-rent project located in Sydney’s Olympic Park, assisted by some tax concessions, namely a 50% discount on land tax for the next 20 years.
Residential property has attracted little interest from institutional investors as retail investors have an investment edge. In the below chart, residential real estate comprised 5% of the S&P/ASX 200 A-REIT index in April 2021 or $6 billion. This is dwarfed by the value of the currently ‘beaten-up’ discretionary retail ($34 billion), industrial ($49 billion), and office ($26 billion) real estate assets listed on the ASX.
In our view, there are three structural reasons why retail investors rather than institutional investors are the primary buyers of residential real estate in Australia.
Capital gains tax breaks for homeowners ‘crowds out’ corporates
Firstly, in Australia, the tax-free status of capital gains for owner-occupiers selling their primary dwelling bids 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 $108,000 in capital gains tax. In contrast, 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 home, anticipating tax-free capital gains not available to institutional investors such as property trusts.
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 positively geared asset generates income above maintenance and interest costs, and obviously, neutral gearing generates no income after expenses and interest.
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 annually, generally an unattractive position. However, under Australian tax law, individual 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 cash flow is negative to maximise their near-term after-tax income and bet on capital gains.
Whilst companies and property trusts can also access taxation benefits from borrowing to buy real estate assets, a wealthy 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 is not attractive for listed vehicles. At the moment, the ASX 200 A-REIT index offers an average yield of 4%. This compares favourably with the yields from investing in residential property. SQM Research reported that the implied gross rental yield for a 3-bedroom house in Sydney is only 2.7%, with a 2-bedroom apartment yielding slightly higher at 3.4% in April 2021. After borrowing costs, council rates, insurance, and maintenance capex, the net yield is estimated to average around 1%. This low yield on residential real estate contrasts sharply with the average yield after costs on commercial real estate currently above 4.5%. As listed property trusts traditionally attract investors that are focused on yield and many property trust CEO’s are remunerated based on growing distributions per unit; there is a strong incentive for Listed Property trusts to buy higher yielding commercial property and avoid lower yielding residential assets.
While housing comprises the most significant component of the overall stock of Australian real estate assets and talking about house prices is the one sport that unites all Australians, residential real estate holds little interest for institutional investors, especially for income-focused investors such as Atlas Funds Management.
Speculating on houses and apartments is one of the few areas of investment where retail investors have an advantage over well-resourced institutional investors.In the future institutional investors could play a greater role in owning residential real estate as they do in the UK and the USA. However, this would require either the extension of further tax concessions to corporates or alternatively removing these concessions such as negative gearing from households, two politically very unpalatable courses of action.
“Things are never as good as they seem or as bad as they seem“ Legendary investor Sir John Templeton
Last week the ABS (Australian Bureau of Statistics) released the Australian unemployment rate for February 2021, which surprised the market, coming in at 5.8% with 88,700 new jobs added since January. This positive news caused us to reflect on where we were a mere 12 months ago and the journey that the economy and equity markets have made from the depths of despair prevailing on this day twelve months ago; 23rd March 2020.
Panic Stations March 2020
Twelve months ago, today, the ASX 200 fell -5.6% to 4546 with $11 billion worth of shares traded, making this day one of the top 20 busiest days in ASX history. The Australian dollar had crashed to an 18-year low of 57c, oil was at US$22 a barrel, and earlier on in the week, the RBA announced an emergency 25 point cut to interest rates. More alarming for investors were headlines predicting a severe recession with many businesses going into receivership and unemployment to reach levels last seen in the early 1990s or the 1930s. In the USA, a Federal Reserve Governor predicted that the US unemployment rate would hit 30% due to shutdowns to contain the virus and the US Congress failed to pass a $1 trillion Covid-19 aid plan.
Questions were being asked about whether commercial real estate and infrastructure would become stranded assets, as Covid-19 was likely to permanently change human behaviour, negating the need for offices, shopping centres and toll roads.
How the crash was different
The crash in March 2020 differed from previous market crashes of 2000 and 2008/09 in that virtually the entire ASX was sold down heavily, even companies that were expected to do well during Covid-19 shut-ins. Atlas viewed that this selling pattern occurred due to the increasing influence of index funds and geared index funds on the stock market. When these funds received redemption, the manager mechanically sells shares in every company in the ASX 200 following its index weight. This saw sharp falls in the share prices in March 2020, even for companies such as JB Hi-Fi, Wesfarmers, Sonic Healthcare and Amcor that were likely beneficiaries from lock-downs and increased testing. Indeed, on this day 12 months ago, JB Hi-Fi revealed that March quarter sales had surged by +9%; nevertheless, their share price fell -11% to $24.61 on market capitulation.
The banks were viewed as the canary in the coal mine and were expected to wear heavy loan losses from rising bad debts. For the following year, Westpac forecasted an 8% contraction in GDP, unemployment at close to 9% and house prices to fall 20% by the end of 2021. Consequently, bank shareholders felt the heat as dividends were either cancelled or suspended. While ANZ, Westpac and NAB cut their dividends during the Great Depression, both World Wars, the 1991 recession, and the GFC; one had to look back to the banking crisis of the 1890s to see the last time that major banks declined to pay dividends to shareholders, as was done in early 2020.
The path back March 2021
While it would be premature to declare victory over Covid-19, none of the doomsday predictions made twelve months ago has come to fruition, and any decision made in March 2020 to panic and liquidate equity portfolios would have been a poor one for investors. Indeed, 23rd March 2020 marked the bottom for equity markets globally.
Previous downturns such as 1982/83, 1992 and 2009 were quite different from what we saw in 2020. While in 2020, unemployment spiked and the stock market crashed in March and April, the levels of fiscal stimulus are much more significant. The Rudd Government’s $42 billion stimulus packages from 2008/09 were dwarfed by the $257 billion in direct Covid-19 related support measures. Moreover, Australia has seen very low to no community transmission of Covid-19, which has allowed the economy to function with fewer impediments than experienced in Europe and North America.
The recently completed February 2021 reporting season has seen companies outperform expectations on revenue, earnings and dividends. Earnings upgrades came from banks (with fewer bad debts) and resources (higher commodity prices). Dividends were the highlight of the reporting season, with many companies increasing payouts to shareholders, potentially recognising that dividends were cut too hard in 2020. Currently, the ASX 200 is a mere 5% below the highs set in February 2020, unemployment has declined from a peak of 7.5% in July 2020 to 5.8%, and retail sales are above pre-Covid 19 levels.
Finally, as following house prices is the one sport that unites all Australians, far from falling 20%, the most recent CoreLogic RP house price index showed that house prices were up +3% over the past year led by Sydney and Brisbane. Stable to rising house prices have seen bad debts for the banks significantly below expectations and seen rising capital ratios. This paves the way for higher dividends throughout 2021 and even bank share buy-backs, a scenario unthinkable a mere 12 months ago!
I have had the “fortunate” experience of having observed three major crashes; March 2020, the GFC in 2007-08 and the Tech wreck in North America in 2001 from the front lines.During these dark periods, the portfolios were populated with companies paying dividends from stable recurring earnings such as TransCanada Pipelines and Amcor, with no exposure to companies reliant on the previous frothy market conditions Pets.com, Nortel, Babcock & Brown or Allco Finance.
What I learned from these experiences is that a portfolio constructed in a conservative manner populated by companies paying stable dividends with low gearing will bounce back from the blackest nights of doom and gloom. Additionally, as markets are driven by human emotions, at the period of maximum despair (March 2020), many investors make irrational decisions based on the view that share prices now only go down. Panic conditions on share markets can result in profitable investment opportunities for those that can avoid the noise. However, it is much easier to make this statement with the benefit of hindsight after the doomsday scenarios for the economy and corporate profits have not eventuated.
February proved to be a very eventful month initially dominated by Australian corporate earnings, which were much better than expected and revealed that corporate Australia is recovering from Covid-19 must faster than expected. In the second half of the month, the main focus was on rising bond yields and what this means for stocks rather than corporate earnings.
The Atlas High Income Property Fund gained by +0.74% in February, a pleasing result ahead of both the benchmark and the wider Listed Property sector that declined almost -3%. The February reporting season held few surprises for the companies we own, as rent-collecting trusts offer greater earnings visibility, whereas trusts with development earnings can be volatile.
Overall, we were pleased with the companies’ financial results that we own in the Fund. The common themes were profits recovering, rents being collected, and the outlook for 2022 looking much clearer. Unlike going into the GFC, the listed property sector faced no debt issues in 2020 as the industry had low gearing, faces low interest costs and most importantly, a spread of debt maturities.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2021.