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I have been buying listed property exchange-traded funds (ETFs) over the last year. So far, it has not been a rewarding investment as the listed property index is off just over 10% over the period. However, that is before dividends. Dividends have been chunky at around 9%. That means that, overall, one is down around 1%.
Over the same period, the Top40 is flat, excluding a dividend yield of some 3%.
I want to delve into why I like property, but also why I may be wrong, especially in the short term.
The bull case for property is fairly simple. One buys when the yield on property is above the ten-year government bond rate. This is currently around 8.1% and the sector is yielding over 9%, so that box gets ticked.
The second bull case is to buy into the sector when the price is around or below the net asset value (NAV) of the property stocks. Again, this is the current situation, so now we have both bull-case boxes ticked.
Except, of course, that prices keep falling. It is important to mention, however, that this will often be the scenario. Just because a share or sector is cheap does not mean it will stop falling.
But there are risks… plenty of risks.
The first risk is that yields will fall as the listed property stocks are unable to pass on inflation-based rental increases in a tough economy. Certainly, the power here sits with the tenant. The landlord would rather have a lower increase in rental income, or even maybe a decrease in rental income, than lose the tenant.
But while income could be lower, costs will continue to rise at the rate of inflation. This means a squeeze on profits.
Furthermore, in the current economy we are often seeing higher vacancy levels. This will again depress overall income and occupancy levels.
The second risk is that the NAV may be under threat. Most listed property companies update the NAV on a rolling basis of between three to five years. So, in a worst-case scenario, we could see a five-year valuation being used that gets downgraded at the next review period.
As NAV drops, debt could become an issue. This is because many listed property stocks have debt covenants that require debt to be a certain maximum percentage of NAV. So, suddenly, the landlord could be in breach of their debt covenants and have to scramble to either sell buildings or restructure debt.
Another response could be to cut back on maintenance on their buildings in order to free up cash for debt repayments. But this road will, of course, only lead to ruin.
While listed property is certainly cheap by classic valuations, there is indeed risk in the short term. But it is that short-term part that has seen me buying.
When I am buying for my long-term portfolio, I am asking myself what I expect to see happening in ten years’ time, not over one year (or even over three years). So, when I was buying property ETFs, I was looking out to 2028. Do I still expect the economy to be struggling to keep its head above water? Do I still expect rentals and NAVs to be dropping? The answer to both is no, I do not. So, I use this valuation opportunity to stock up on assets that have a solid long-term future.
A last point here is that I always buy into ETFs when investing in property. Sure, I have a few preferred listed property stocks, but listed property has never been an area in which I’ve felt comfortable enough buying individual stocks. An ETF offers a basket of property stocks that will change over time, leaving me free to not have to worry about picking individual stocks.
This article originally appeared in the 26 September edition of finweek magazine. Buy and download the magazine here or subscribe to our newsletter here.
