Volatility natural part of property

By BRENT SHEATHER

If you want to put your money into property, one of the choices is between investing in a syndicate - buying a stake in one building or a group of them - or buying shares in a property company.

On the face of it, property shares look to be a better deal than a syndicate. Because shares are listed on the sharemarket, that means real time pricing, institutional investors, higher quality, liquidity, lower fees etc.

But there has to be a catch, right?

Of course there is. Listed property is really shares pretending to be property. At the first hint of sharemarket jitters, the whole lot will come crashing down and all those poor mum and dad shareholders will have only their state super and Radio Pacific to console themselves with.

At least that's what many of the people who flog unlisted property syndicates would have us believe.

Fortunately, reality is a bit different. In times of recession, is there any reason an office building portfolio listed on the sharemarket should have higher vacancy rates than an unlisted portfolio? I can't think of one.

Will the sales of a listed shopping centre portfolio fall more quickly in a downturn than those of an unlisted portfolio? Of course not.

After September 11, did the occupancy rates of listed hotels fall further than those of their unlisted counterparts? I don't think so.

Looked at dispassionately, these are absurd suggestions. But this is the line frequently put about by people who sell unlisted property assets.

Syndicating property, then flogging it to mums and dads, has been one of the best games in town for a long time now.

Because property valuations can be made with about as much precision as working out Enron's profits, the budding entrepreneur can buy a property, load it with 5 to 10 per cent in various up front fees then sell it in $5000 pieces without a worry about comparative pricing or a thought about how their customers might realise these investments.

One of the central selling propositions of the syndicators is that syndicated property really is property, but if you list that property on the stockmarket, watch out, in some nightmare scenario the property morphs into ... risky shares. God help us.

A stockmarket listing permits an asset to be priced continuously whereas an unlisted property is valued periodically - usually every six or 12 months.

The anti-listed property camp argues that property, when listed on the sharemarket, becomes more volatile than its underlying risk implies.

To see if this is the case, we need to understand what drives property values, whether these factors change continuously or six monthly, and ask if there is any plausible reason these factors might affect listed property more than unlisted property, making it more volatile.

Despite what one hears from various investment experts, property values dance to substantially the same tune as shares or, for that matter, any other asset. As always, the foundation is cashflow adjusted for risk and the time value of money.

Obviously these factors (interest rates, a premium for risk and estimated future rentals) change continuously - all a six or 12 monthly valuation does is suppress the underlying volatility of the asset and concentrate the valuation process in the hands of a few people (as opposed to the actions of the many analysts and institutional investors which determine sharemarket values), who may or may not be in the pocket of the vendors of the property.

The sharemarket's prime function is price discovery, representing as it does hundreds of thousands of people's views on what each company's dividend streams are worth, discounted to reflect risk and the time value of money. This happens in the same way for all businesses listed on the market.

As Charles Froland says in his classic article "What Determines Capitalisation Rates on Real Estate" from the summer 1987 Journal of Portfolio Management, "the cap rate is the child of the capital markets, just as it should be".

What Froland's analysis means is simply that if interest rates rise or demand falls (as was feared after September 11) the value of a property should decline, for exactly the same reasons as the sharemarket falls.

So, far from being illogical, the volatility of listed property is completely rational in that it allows the valuation drivers of the asset to manifest.

This view was recently echoed by Alistair Ross-Goobey, chief executive of Hermes Pension Fund, one of Britain's largest institutional investors.

He said at a European property conference that in Hermes' view the volatility of listed property assets was an advantage as it reflected the intrinsic risks of property assets, whereas property valuations seemed "incredibly smoothed and react some time after the change in fundamentals".

For unlisted property with valuations every 12 months or so, real-time pricing is impossible. Do the valuers of an unlisted hotel portfolio run back and rework their sums after September 11? No they don't. Instead, there is a set six monthly or 12 monthly, or longer, valuation date - too bad if things change dramatically in between.

Looked at this way, it is quite easy to see the attractions of the real-time pricing the sharemarket permits.

Whereas the proponents of unlisted property securities say listed property is really shares, the facts suggest that not only is listed property not like shares it is becoming less and less like shares.

US investment research house Ibbotson Associates in a report published last year found that the returns of the real estate sector of the US sharemarket were becoming less and less correlated with returns from the broader market.

Incidentally, Ibbotson also concluded that adding real estate shares to a portfolio was a significant source of diversification, raising returns and lowering risk in a wide range of alternative portfolios. Other research has suggested that listed real estate stocks have a negative correlation with technology shares. (This news comes a bit late for many Nasdaq investors).

The biggest underlying weakness of many syndicated property and unlisted markets is that there is no independent, expert determination of value, compounded by no institutional involvement, high transaction costs and in some cases questionable management.

Illiquid property markets are not sufficiently in tune with the bond, equity and securitised property markets, so mispricing occurs.

Add valuation inefficiencies, heavy borrowing and an inability to raise extra equity and you have a recipe for disaster.

An extreme example of the mispricing that arises from the valuation smoothing in the unlisted property sector was the great Australian unlisted property trust crash of 1990-1991.

Various fund managers, including the odd fund manager of the year, thought they had died and gone to heaven when they discovered that if they continually revalued their properties higher and higher and at the same time suppressed volatility, naive investors would invest more and more money in their funds (which produced more and more management fees).

Unrealistic property valuations weren't a problem when the funds were growing, but the fun ended when a few people advised investors to withdraw funds.

At first, redemptions were financed by cash reserves and then borrowing, but eventually when there was a stampede for the exit the funds were suspended and people couldn't sell out.

Because the fund managers let the first people who wanted their money out to exit at unrealistic valuations there was a leveraged impact on those who stayed in the fund.

Far from being safe, when the funds were finally listed on the sharemarket, valuations plummeted, in some cases by up to 90 per cent.

There is no doubt about it, listed property is more volatile than its unlisted counterpart. But this is the price of a continuous rather than a discrete valuation process.

This is exactly how it should be. The valuation drivers of property themselves are volatile, but this simply reflects reality. Anything else is contrived and unsustainable.

The sharemarket occasionally gets it wrong, but for someone who is not an expert property investor the market's view of the worth of a property is at least independent and more often right than wrong.

* Brent Sheather is a Whakatane sharebroker and investment adviser.