With bricks and mortar still an attractive investment over shares, property syndicates are rising in popularity, but how do you assess them?

The poor performance of the sharemarket in recent years has resulted in investors reweighting their portfolios and a subsequent increase in demand for both residential and commercial property.

Negative returns from shares combined with several high-profile corporate collapses and a general disquiet about corporate management makes "bricks and mortar" an attractive investment. After all, property is a tangible asset and offers a high level of control. But not all investors choose a hands-on approach to acquiring and managing property assets. Some would prefer to leave this process in the hands of property professionals. This, along with a general increase in demand for property, has accelerated the already well-developed property syndication business.

Property syndicates can provide effective exposure to commercial property without the hassles commonly attached to the acquisition process and ongoing ownership. Of course, there are several avenues available to investors wanting property exposure and probably the most common is direct purchase, but there are also unlisted property funds (unit trust structure) offered by large investment institutions such as AMP, Deutsche and the Commonwealth Bank. Listed property trusts do not offer the same investment characteristics as unlisted/direct property investments.

Like all types of investments, it is necessary to do as much research as possible to ensure your investment capital is being allocated correctly. Property syndicates are not risk-free investments and there may be a substantial difference between individual syndicates.

A property syndicate offers investors a part ownership (most often through a unit trust structure) in a property or a portfolio of properties. Factors to consider when assessing and monitoring property syndicates are similar to that of direct property ownership. Most property syndicates are fixed-term and rely on the eventual sale of the asset for the return of capital. Issuers/managers of property syndicates generally target properties that have long-term leases. This enables the issuer to provide a secure yield with some remaining lease duration before the sale. Nevertheless, the sale price can be affected by the prevailing property market conditions and micro-factors such as competition from newly completed buildings, all of which are difficult to assess many years out from the original date of purchase.

When investing in a property syndicate, the due diligence process has already been undertaken by the investment group offering the syndicate. The property market research, financial analysis, building and engineering reports and review of lease documents are undertaken by either the responsible entity or a consultant. You need to examine the prospectus to ensure that what you are buying into is reasonably priced and without substantial risk.

One of the key attractions of property syndicates are the high yields. Yields range from 8 to 12 per cent. The high yields are generally achieved through gearing the property where the cost of debt is significantly lower than the after-costs yield of the property. This amplifies the returns in both directions.

If the property investment produces good capital gains, the return to investors will be increased further from gearing the investment, but if the property shows a capital loss then the use of gearing will decrease the returns to investors. But gearing a property transaction is not at all unusual and investors should not be worried about gearing levels below 60 per cent, as long as interest rates are fixed and asset quality is good.

The yield that the property has been bought on can tell a great deal about the financial and physical attributes of the property. If a property sells on a high yield there is generally a reason. Properties can show high yields due to four things: over-renting, a secondary location, poor condition/building quality and markets with minimal barriers to entry.

Some issuers target over-rented properties to achieve a high yield that brings in the investors. If the rents are inflated, the income levels from the property will be unsustainable and will eventually negatively affect income distributions to unit-holders and potentially the future capital value of the property.

Over-renting has been discussed in previous issues, but relates to the situation where the contract rent (rent payable by the existing tenants) is greater than the market rent (the rent that could be achieved in open market conditions). If the contract rent is substantially higher than market rent when the existing leases expire, the syndicate may be unable to re-lease the property at the same rent.

The ideal property to syndicate over a fixed term should be low-risk in respect to location, age of the building, tenant quality and lease expiry profile. In this respect, prospective investors should be looking for a modern building with limited capital expenditure requirements that is well leased to secure tenants. Also, a property with a prime or central location will have a ready market and is likely to be more capital-secure over the investment term. Buildings that are old and in secondary locations will offer a higher yield, but with greater risk. Capital expenditure is often required to maintain the building at a certain standard and to attract new tenants. Buildings in secondary locations may have long vacancy periods when existing leases expire.

Certain types of properties and certain locations have low barriers to entry. Industrial properties are easier to construct than retail and office properties. This means that the market dynamics can quickly change from undersupply to oversupply, adding to income and capital volatility. As such, industrial properties have historically sold on yields that are higher than retail and office. Investors should not be attracted by yield alone, as a high yield could mean that income distributions or the final capital value is less secure.

Market research and financial analysis of a prospective property purchase is crucial to the success of the investment. The prospectus covers all the details of the market research and analysis. The prospectus should include details of the property being offered and commentary on the state of the property market and the variables pertinent to the property such as current market rents, yields, vacancy levels and location characteristics. There should also be several independent reports including a valuation report, a building engineer's report and an accountant's report.

Certain assumptions such as letting-up periods, market rental growth, capital expenditure requirements and outgoings budgets need to be made to produce the distribution forecasts. It is important at the outset to ensure that the forecasts are not overly extravagant and are backed up by market research/observations.

At the beginning of a five or seven year investment term, most people are thinking about the more immediate income return rather than their eventual return of capital. But this is where property syndicates went wrong a decade ago. Investors should be looking at all of the facets of the property from a return of capital perspective. Are there barriers to entry that will ensure its long-term value is easily maintained, such as a good location, a tightly held market and a substantial building structure? If the property is in a fringe location, the physical structure has little value, and the major feature is the length of the lease covenant, then the investor is taking on substantial risk.

Investors who can remember back to the liquidity failure of unlisted property vehicles in the early 1990s will know that property syndicates can be a relatively illiquid asset. More often than not, investors get caught up in an investment trend or in a market that has moved beyond fundamentals. When this occurs, there is generally going to be an unsavory end.

Commercial property values had escalated by 50 to 60 per cent over a three-year period leading up to the collapse of the market in 1992. While the illiquidity of the investment vehicles stopped people getting their money out, it was really the overvaluation of property prices and the eventual correction that ended in investors losing money.

Direct property funds generally provide exposure to passive property investment with relatively low risk. Some of the newer style of funds provide a higher risk/return profile by providing exposure to property development.

The property syndicators
The top five property syndication groups (by capital value) include MCS Property Limited, CPT Manager Limited (a division of Centro Property Group), Macquarie Direct Property Management Limited, Australian Unity Funds Management Limited and Investa Properties Limited. Some of the other smaller syndicators include Peet & Co, Austgrowth Property Syndicates and Opus Capital.

Some of the largest syndicate offerings have included Centro Property Syndicate No. 8, with a total asset value of $290 million; Macquarie Martin Place (total asset value $230 million); Westpac Moorebank Property Trust 4 ($207 million); MCS 9 1998 National Retail Portfolio ($146 million); and MCS 17 Direct Property Investment (118 million).

Centro Property Syndicate No. 8: Centro is one of Australia's largest retail property syndicators and managers, with 56 shopping centres and $2.9 billion of retail property under management. Syndicate No. 8 is open for subscription and provides exposure to a 50 per cent interest in a regional shopping centre in Bankstown and CBD retail facility in Perth. The forecast income return is 8.2 per cent a year and is largely (about 70 per cent) tax-advantaged.

The syndicate offers good geographic and tenant diversification, with the Bankstown property having five major anchor tenants (Woolworths, David Jones, Kmart, Target and Franklins) and 237 specialty stores, and the Perth property having David Jones and six specialty shops.

Centro, as well as being the manager, is also the cornerstone investor in the product. Centro is well versed in the management of retail assets and has a good track record in managing risk and adding value.

Austgrowth Property Syndicate No. 16: Austgrowth is a smaller syndicator that tends to specialise in higher-yielding, single-property syndicates. Austgrowth has undertaken 17 syndicates for properties in Sydney, Canberra, Brisbane and Melbourne.

The current No. 16 syndicate provides exposure to a two-storey commercial office building with car parking for approximately 120 vehicles situated at Mulgrave, about 22 kilometres south-east of the Melbourne CBD. The property is fully leased to Automatic Data Processing Limited until April 2008, with a further five-year option period. The syndicate has a five-year term and a forecast income return of 9 per cent a year.

This is a reasonably high yield, but is not without its risks. Investors are largely exposed to the financial security of a single tenant in a regional office market environment. It is a five-year lease term that puts significant emphasis on being able to retain the tenant before the sale of the building.

Specific Property Services Sydney Healthcare Trust: Specific Property Services is a member of the SAITeysMcMahon Group, which has 25 syndicates across $450 million in assets. The group generally provides exposure to specialist properties at yields of 9 to 10 per cent.

The current syndicate, Sydney Healthcare Trust, offers exposure to several suburban medical centres in the Sydney metropolitan area. The syndicate has a 10 to 12 year term and a forecast income return of 9 per cent a year in the first year. The properties are newly constructed and leased to Primary Health Care on 20-year leases.

While there is some diversification in having several properties in the portfolio, investors are largely exposed to the financial position of a single tenant. These are all purpose-built properties that would require additional capital to be converted to broader uses.

Risk and return
When examining property syndicates, investors need to look beyond the initial period and take into consideration the risks associated with each investment, and whether these risks are suitably priced.

When property markets are improving and the state of the general economy is healthy there is less risk. It is when these fundamentals change that investors start to encounter problems. Property syndicates are illiquid investments and investors should take a conservative, low-risk approach when assessing them.

Checklist

Are there major risks to realising the value of the property at the end of the investment term (locational and property-type barriers to entry)?

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