Don't be put off by the doomsayers

By BRENT SHEATHER*

In Weekend Property in the last Weekend Herald, Ed Schuck, a consultant with the New Zealand office of investment advisers Frank Russell, said property was a bad bet as an investment.

This criticism is not only without merit on the basis of historic performance, it ignores the fact that the present fundamentals of property versus equities and bonds are highly attractive.

More importantly, United States research shows that adding a property component to a portfolio of equities and bonds can reduce risk substantially.

In New Zealand the benchmark for most retail and many wholesale investors is the NZSE Gross Property Index. Over the short term, the listed property market has performed all right, outperforming shares by 220 basis points over 12 months. It has come in midway between shares and bonds over three years.

These are adequate returns but nothing to get excited about.

Fortunately, as rational investors, we are not limited to the NZ property market. My average client's property portfolio has a 30 per cent weighting to NZ property, 20 per cent to Australia and 50 per cent to the US and Europe. It is this overseas exposure that has been helpful to performance in the past 18 months.

Property has been a great asset class to be in over the past year. US property outperformed US equities by 46 percentage points in the August year. Over the medium and longer term, property has performed as expected - midway between stocks and bonds.

Morgan Stanley's property research team has described the listed property sector as "walking like real estate, talking like stocks and acting like bonds". This should come as no surprise to anyone.

In many ways property is the most attractive asset class because it can not only provide a high initial yield, but provide a real yield.

It is an inflation-adjusted yield in that rentals grow at around the inflation rate over the long term. In the past 30 years, the dividend yield available from global equities has fallen from 5 per cent to the present miserable 1.3 per cent.

A 1.3 per cent yield does not go a long way. The trick with property, as with shares, is not just to buy one property leased to one tenant in one town, but to diversify over all property types - residential, retail, office, industrial, and then globally as well.

Property's attractions do not stop with reasonable returns and yields.

Ibbotson Associates - a leading authority on asset allocation - examined the historical investment performance of the US Reit sector (real estate investment trusts listed on the Stock Exchange).

It tried to find out if investing in publicly traded real estate companies returned meaningful benefits in diversified portfolios.

Ibbotson found that, historically, Reits have earned competitive returns and exhibited lower volatility than other stock types.

More importantly, Ibbotson's work shows that the correlation of Reit returns to the returns of other stocks and bonds has declined significantly over the past 10 years. From 1993 to last year, the correlation of monthly Reit returns to large stock returns fell to 0.25 and the correlation with small-stock returns fell to 0.26.

The Ibbotson analysis shows that Reits are a significant source of portfolio diversification, raising returns and lowering risk in a wide range of investment portfolios.

What concerns me about Mr Schuck's views is that his "steer well clear of real estate" message flies in the face of what big overseas investors are doing.

Last week, one of the biggest pension funds in the world, Calpers in the US, said it would increase its allocation to real estate.

Legendary investor George Soros said he was setting up a dedicated real estate vehicle for buying European property.

Merrill Lynch Asset Management, one of the big fund managers in Britain, produced a report arguing for a greatly increased weighting to property in portfolios.

Mr Schuck also suggested that life funds in NZ had drastically reduced their property exposure from around 33 per cent of assets a few years ago. This does not fit with the statistics.

Aon Consulting has the average pension funds property weighting hovering around the 5 to 10 per cent range in the past 20 years but never as high as 33 per cent.

In the US and Britain, average weightings are moving up slightly, from the 5 to 7 per cent range.

In Britain, property weightings peaked at 20 per cent at the end of the inflationary 70s.

The thrust of Mr Schuck's investment thesis is that "it has done badly in the past so it will do badly in the future".

But economics tells us that longer-term returns from shares, bonds and property should be roughly equal to the dividend yield plus the growth rate. Risk-averse investors will note that only one-third of property's prospective returns are dependent on that increasingly fickle component "capital gains", whereas for shares the figure is 82 per cent.

In New Zealand, our three largest property firms are yielding between 9 per cent and 10 per cent, although growth could well be zero or less.

These numbers and property's diversification benefits (it went up when tech went down) make a compelling investment case implying at least a neutral weighting in property (5 to 10 per cent).

* Brent Sheather is a Whakatane stockbroker.