Brent Sheather: Cash in on 'magic-run' sector

We have all seen the stories of ordinary Kiwis made rich by property. "Joe So and So started with $25, now he's laughing and the owner of $1,000,000 of residential property."

What the ads might not say is that, coincidentally, Joe's bank is owed about $1 million and Joe is a nervous wreck worrying about what mortgage interest rates are going to do and how he is going to find another tenant for that house down the road.

One of the simplest rules for earning an economic return on your funds is to check that your investment pays a decent dividend. With residential property prices close to highs, and just about anyone able to get a mortgage, yields generally aren't all that flash - maybe 4 per cent for a three-bedroom house in Remuera less rates, insurance and so on.

For sure, there are higher-yielding residential alternatives but the trade-off is usually a lower propensity for growth and more tenant hassles.

But there is an alternative route to riches via property speculations and, despite a stellar 12 months, it looks to be a better bet than residential.

It is, of course, the local listed property trust sector and with just a call to your friendly stockbroker, or even a click on a mouse, you can be a part-owner of some of the finest office, retail and industrial property here. No seminars, no mortgage and no tenant hassles.

The sector has had a magic run during the past 12 months with the index up by 20 per cent and the likes of Property For Industry (PFI) and Kiwi Income doing even better at 38 per cent and 33 per cent respectively.

Yields at 6.5 per cent to 7 per cent no longer look a "no brainer" but are still attractive if you see what is happening in US and European markets.

Overseas, property is almost today what technology was in 2000 and some prime retail and office deals are being done under the 5 per cent mark. Relative to this and 4 per cent from Remuera residential, 7 per cent is compelling.

Prospective returns are also promising: economics tells us that return equals dividend yield plus growth.

The local property sector yields around 6.5 per cent so assuming rental growth in line with inflation at 3 per cent plus an extra 0.5 per cent pa in developmental profits gets us to that magic 10 per cent number.

What is also attractive about the property trusts is that many of the tenants are reasonable-sized companies which act professionally, don't trash the place and generally pay the rent on time.

Besides that's not the unit holders' problem anyway - it gets looked after by the manager whose job it is to negotiate the rent, keep the place tenanted, pay the bills and direct credit what's left over to the unit holders' bank account.

Sounds just about perfect - just about - but not quite.

As Brian Gaynor has pointed out more than once, NZ property trusts don't manage themselves - they have external managers whose fees are, for the most part, a function of the amount of assets managed.

This introduces the potential for the managers to put their interests before that of the unit holder.

The most common manifestation of this bias is for the manager to buy assets which are non-accretive to earnings; in other words buying assets which are expensive and don't lead to higher earnings per share, to increase the funds under management.

The manager wins because the management fee is largely a function of the value of the assets under management whereas ordinary people are primarily interested in increased dividends per share and by default a rising unit price.

Incidentally, property trust managers can ensure a more intelligent market in the property trust sector by resisting the temptation to trumpet their "profit after tax" increases and instead highlight earnings per share and dividend per share which is the bottom line for investors with 10,000 shares.

Typically in NZ, we see property trust "A" disclosing an impressive increase in NPAT of 30 per cent to 40 per cent, due to a greatly enlarged asset base but, at the same time, earnings and dividends increase by a modest 2 per cent to 3 per cent pa.

This sort of media release is a bit of an insult to the intelligence and perhaps even hints at the independence of directors.

In the world's biggest Reit market - the US - external management is virtually unheard of. All the property companies there are internally managed so the management's interests are better aligned with those of unit holders.

There is quite a push for internal management in Australia too with majors like Westfield and Macquarie Goodman Group adopting the internal model recently. The news was greeted enthusiastically by the sharemarket with substantial and immediate share price gains.

Don't expect the same here any time soon but local institutional shareholders have negotiated some improvements in management contracts in the last 12 months and there may be more to come.

There are other less obvious benefits of the listed sector too over owning residential investment property - you can reinvest your after-tax dividends in extra shares, often at a small discount to the market price. You can add to or exit from your investment quickly, easily and often at a lower cost and you can deal in small amounts - handy if you need $15,000 for a new car.

Despite the hand-wringing, property investment is a favourite of New Zealanders so perhaps the stock exchange should be spending less time developing the more speculative and esoteric aspects of the sharemarket like warrants, options and margin trading and instead try to cater more for the serious saver who is likely to commit more funds and be around a lot longer than your average margin trader.

There must surely be a market for a listed residential fund which could enable investors with one property to diversify prudently and get the thing professionally managed for a reasonable cost and, at the same time, allow someone saving for a house or leaving the country for a while to properly hedge their position.

A decent exposure to listed property will boost the income and lower the risk of most share portfolios.

This latter aspect of property - stability - is particularly handy in those times when the sharemarket keeps falling and the future looks dim.

Nothing like a dividend cheque in the mail to improve the mood when your portfolio looks sick.

* Brent Sheather is a Whakatane-based investment adviser. He is a shareholder in the stocks mentioned.