There was recently an article in the Australian Financial Review on unlisted property, debt and liquidity which raised some points we felt required further consideration, which is the subject of this note. The first of these points concerns debt and gearing. Here are a few key extracts from the article:
“Investors are at risk from a new generation of unlisted property fund managers who are ‘super turbocharging’ returns with unsustainable levels of borrowing.”
“[gearing] above 50 per cent should prompt an investor to ask questions”
We consider this to be a binary view of gearing, suggesting that any investment that has gearing of 50% or more is “aggressive”. When it comes to debt and leverage, context is everything. In the hands of a chef a knife is a highly useful tool, in the hands of the wrong person it is a weapon. Debt is no different, and over the last two decades we have seen many well credentialed managers prudently use debt, often at 50-55% gearing, to create real investor wealth.
For the right asset, we contend that 50% gearing is not necessarily high. During the GFC and in the period since we have seen many highly performing assets with gearing of 50-60% that we would not consider ‘aggressive’. Conversely, we have seen many conservatively geared assets with terrible investment performance and substantial downside risk. After all, it is not the level of gearing that determines asset performance, it is the asset geared against. All gearing does is magnify the performance of an asset and to focus on gearing alone is to ignore the obvious driver of poor performance, being asset selection.
The second contention of the article concerns liquidity. Here are a few of the key sections:
“high gearing and growing liquidity risks could trap investors in underperforming funds or trigger fire sale [and]… when the 2008 global financial crisis hit, many investors were trapped in unlisted funds because managers were caught with high levels of debt they struggled to service and properties they could not sell.”
“many investors are wary of unlisted funds because they ‘took a bullet’ when they could not withdraw their investments after the global financial crisis”.
Being trapped in an underperforming fund is highly undesirable. Having said this, the alternative of unrestricted liquidity can be even more damaging. In both the GFC and COVID, a lack of liquidity actually preserved wealth in many cases. This is evidenced by the divergent performances between the listed and unlisted markets through these two downturns despite exposure to the same underlying market. During the GFC the A-REIT sector fell ~80% in value whilst the unlisted market fell ~30%. A similar fall in listed values was seen in 2020, again from the AFR article:
“Listed property had a massive 50 per cent plunge to its pandemic low in March last year….. By contrast, unlisted property did not slump in the first half of last year and has instead seen modest write downs in asset values – reflecting the pandemic’s impact on office and retail property”
It’s curious as, to us, the obvious takeaway from the above is the divergence of listed and unlisted property, but that is not what the article is communicating. In fact, the negative effects of liquidity are seldom discussed. Using the language of the quote above, do we read this that it is ok to ‘take a bullet’ in a listed structure, but not an unlisted one? As the above A-REIT examples show for those that did liquidate, the cost to their personal capital was immense. Conversely, when funds lock down the concomitant lack of investor control is far from ideal, but a skilled manager can be best placed to turn a position around in a downturn to preserve wealth.
We are not at all suggesting that high gearing and a lack of liquidity is the optimal investment model. What we want to provide is an alternative perspective, and one that is not often discussed. Gearing and illiquidity are not ‘bad’ – they have to be used appropriately, in the right setting, and with the right asset(s). If this is done, they can drive fantastic investment performance.