Brent Sheather: Property syndicates - bad value, poor disclosure, great fees

Mum and Dad investors are being urged to invest in property syndicates with forecast pre-tax returns. Photo / iStock

Post the financial crisis of 2008 central banks around the world have decided that low interest rates are necessary to save the world and, according to the Bank of England, are here to stay for a good deal longer.

Unfortunately there are unanticipated side effects of low interest rates and one of those is that they tend to incentivise investors to do things that they wouldn't otherwise do, with taking on more risk at the top of the list.

Apparently retail investor lemmings in China lend their money to shadow banks promising 9 per cent with little or no consideration of their ability to return the capital, Mr & Mrs Watanabe in Japan buy American government bonds without considering fx risk and retired Aussie battlers buy high yielding bank shares without giving too much thought to the fact that their equity is at least 10x leveraged.

NZ investors are not immune to these forces and of late mum and dad are being urged to invest in property syndicates with high pre-tax yields. Before we take a look at property syndicates we should recall Charles Froland's famous paper where he noted that property "capitalisation rates are the child of the capital markets."

What he meant here was that the valuation of property is no different to any other investment asset in that its net present value is a function of current and forecast interest rates.

Investors are moving funds from bank deposits because rates are low but they need to appreciate that the high tide is lifting all boats.

Because of low interest rates property syndicates are, despite appearing stupid on just about any measure and being the subject of a warning from the FMA, apparently still very popular with mum and dad investors.

This column has covered the topic several times before, most recently in the Herald article "It's your money, fool" on 23 April 2014.

Rather than speculate as to whether property is expensive or not today we will compare property syndicates with listed property trusts to get a view as to which vehicle offers non-expert retail investors the best value and safest exposure to commercial property.

Hint: it isn't property syndicates.

Even the FMA don't like property syndicates.

In a 2012 consultation the FMA said that property syndicates have been the subject of a significant number of complaints covering a variety of issues including inadequate governance, deficient management and poor disclosure. The complaints demonstrate a failure of disclosure."

Governance and disclosure are problems but they can be problematic with listed vehicles too. There are much more important differences.

The substantive failings of these schemes relative to listed alternatives are set out below:

• Pricing - with a property syndicate the price is determined by a valuer who works for the property syndicator.

This wouldn't be an issue except often the syndicator is selling the property! Listed property trusts are priced with the benefit of a valuer's knowledge but are also a function of buying and selling by institutional investors who analyse these things in a lot of detail.

So if they think the valuation is too high or too low they will price the fund differently and also have regard to the price of other competing assets like bonds, shares, in real time.

If the property trust is burdened with a terrible management fee or a stupid manager the market price will reflect things. All this considered the stock market produces a fairer price than one valuer and this difference is critical for mum and dad because most are not experts.

• Liquidity - with a listed property trust you can sell out and get your money in 4 or 5 days for a fee of maybe 1.5 per cent.

With an unlisted property trust selling is more difficult and frequently the fee to exit is 2 per cent and you may even have to get the permission of the manager to sell your units.

More often than not there is a large bid/offer spread - 10 per cent and more - and the buyers are often "close" to the syndicate managers so insider trading can be a problem.

• Diversification - with syndicates you normally buy one property with a few tenants in one town in one sector.

With listed property trusts you get the benefits of diversification - lots of properties, diversified geographically and generally the larger listed property trusts have higher quality assets and thus tenants.

• Gearing - the average gearing of the listed property trusts is between 25 per cent and 35 per cent. Gearing on syndicated properties is frequently around 50% and high gearing equals high risk. Note that less scrupulous directors are inclined to advocate high gearing to artificially inflate the yield accruing to shareholders.

• Entry cost - it costs an average of about 1.5 per cent in brokerage to buy a listed fund on the stockmarket.

The all up fees for initial offerings of syndicated properties seems to average a huge 10 per cent which is outrageous and ridiculous.

So ridiculous in fact that a review of the securities law in America just recently has determined that financial advisors who sell unlisted property trusts burdened with high fees must now when they report to clients reduce the value of the clients holding by the extent of the fees paid. Mum and dad are thus confronted, within a month of buying the property, with a 10 per cent loss. Pity we don't have the same law here.

Let's take a brief look at some of the property syndicates currently being marketed to retail investors.

The first thing that struck me in one of the disclosure statements was that establishment costs were almost 10 per cent of the equity being contributed. That is a big hit but things go further downhill from here.

For a start the chapters on costs frequently run to five pages of small print and fees include a manager's offeror fee, brokerage fees, underwrite fees, ongoing fees charged on new leasing, renewals or extensions of leases, assignment fees, refinancing fees, capital raising fees, the list goes on.

But perhaps the biggest issue for prospective investors and the FMA is the lack of disclosure. The average retail investor is likely to look at the headline yield and conclude that the property is valued cheaply because it will generate a high yield but the way they get to the high yield frequently has a lot to do with financial engineering.

If you can borrow at well below the property yield then the return on the equity portion will be high.

So what yield would the property produce without any gearing?

We don't know and this looks to be a major failing by the FMA to have allowed product disclosure statements in their current form. How this could happen in 2016 after all the new laws, rules and backslapping is a mystery.

There are a lot of other issues with property syndicate product disclosure statements not least of which is the fact that the significance of key variables is obscured by non-material details.

What is the FMA to do?

Clearly the new rules haven't proved to be much good.

One solution might be to ensure that the financial advisors' Code of Conduct requirement, that advisors put their client's interests first, is actually enforced in a manner that the man on the street could empathise with rather than the current situation where just about anything goes.

Recommending a fund with huge initial fees, various unquantified ongoing fees, an uncertain valuation and no defined mechanism for selling out doesn't really look like putting client's interests first particularly when there are lower cost, lower risk alternatives.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.