The Australian real estate market is expected to correct substantially in 2009, a development that could be exacerbated by pension funds with heavy allocations rebalancing their portfolios. However, as Lynn Strongin Dodds reports, Australian pension funds will remain firmly committed to the asset class
Australia may not be suffering the same economic body blows as other countries, but real estate assets have definitely taken a hit. The listed sector has undergone several bouts of aggressive repricing, while the direct market is expected to follow suit, albeit not as dramatically. Not surprisingly, pension funds are biding their time, but when they do jump back in, it will be with a cautious step.
One of the issues is calling the bottom of the market. Last year, listed property trusts, also known as real estate investment trusts (REITs), plummeted by about 60% and many superannuation funds have sought redemptions from household names such as AMP Capital Investors, Colonial First State, Dexus Property Group and Lend Lease.
According to a recent report by US-based bank JP Morgan, 22 of the most highly leveraged REITs, which include Macquarie Countrywide and Tishman Speyer Office, are estimated to have about $32bn (€25bn) worth of debt, which accounts for 94% of their enterprise value.
As a result, it could be another few months before the listed market stabilises. Jennifer Johnstone Kaiser, head of property research for Asia Pacific research at Mercer, notes:
"The Australian banking and financial system is fundamentally strong, but we are under pressure and there will be more pain in the next two quarters. The case for property, though, is still there. It is a defensive asset class that can be held for long-term growth and as a hedge against inflation.
"However, I think we will see clients return to basics and less complicated structures. They will look at each opportunity on a case-by-case basis, but the criteria will be high income flows, tighter and more transparent financial reporting, governance and transparency."
Ross Barry, the Sydney based head of portfolio construction and diversity at Watson Wyatt adds: "Most superannuation funds can afford to have a long-term horizon on property. There is a reasonable expectation that property will be one of the first markets to recover, especially in an environment of low (or negative) real interest rates and high replacement costs. It could take, though, another 12 months or more to clear the debt overhang in listed property trusts.
"Not only had gearing levels reached 50% or more in some listed companies, but many had evolved from pure property plays to complex structures with stapled funds management companies and significant development risk on balance sheet. So, in addition to deleveraging, the listed market is likely to undergo significant consolidation and a reversion back to simpler, more transparent structures."
Bruce Murphy, global head of institutional distribution at Macquarie Funds Group, also does not believe the current environment "will scare pension funds away from property any more than other asset classes". He adds: "I believe we will continue to see investors use REITs for global diversification as well as liquidity, although they may wait for markets to stabilise before going back in."
The Australian pensions industry differs from many countries in that it has a mandatory defined contribution system, which offers special tax concessions that are not available to other types of investments. Since the scheme was first introduced in 1992, monthly compulsory contributions into so-called superannuation funds have jumped from 3% of salary to the current 9%.
Three years ago the alternative bandwagon gained momentum as employees were given more choice in terms of investment options. Property remained a popular mainstay due to its relatively low risk and high-yield profile.
Howard Brenchley, director and chief investment officer at Sydney-based APN Fund Management, says: "Institutional investors have always had a high weighting - up to 10% of their portfolios - to property. The asset class was never seen as an alternative investment but as part of the mainstream portfolio.
It was typically divided into three sub-categories: direct investments; REITs; private equity structures, such as opportunity funds, which had a bit more zing in them. REITs became the largest category, although some argue the listed sector should be part of the equities portfolio, while others think private equity types of funds belong to the alternative sector."
Andrew Lill, director of investment strategy for Russell Investment Group, adds: "The REITs market was developed in the early 1990s and was originally used by small to medium sized funds that did not have the resources to go into the unlisted market.
Today, every superannuation fund has an exposure to the listed market, because it is seen as an attractive way to gain exposure to global property in the US, Europe and Asia."
On the direct front, pension funds remain wary, because the numbers are still being crunched. The latest figures from the country's Investment Property Databank (IPD) index show a 10.6% return in the 12 months to September, down from 17.7% in the previous period. By contrast the S&P/ASX 300 A-REIT Index was off 41.8% during the same time frame.
Looking ahead, LaSalle Investment Management predicts that commercial property prices could drop by 20% to 35% this year, as landlords struggle to refinance debt, despite government plans to set up a A$4bn (€2.03bn) fund in partnership with the country's major banks.
One problem, according to Brenchley, is that valuers do not have the critical tools to determine property values, meaning deals will not be conducted until the expectations of both buyers and sellers are brought into line. "In many ways it is a vicious cycle in that the banks have not triggered foreclosures which are allowing borrowers to hold onto their assets," he says. "As a result, there have been very few deals and we do not have an idea of where prices are."
A further drain on prices could be from the so-called denominator effect. This has left many pension funds near their tipping points or overexposed in terms of real estate exposure due to the dramatic falls in equities. There are fears this could trigger more declines in property values as some of the market's most active players move to the sidelines to recalibrate their portfolios.