The COVID-19 pandemic has brought about significant changes in the commercial office and retail property landscape, with work-from-home and home shopping becoming the new norm across the globe. The occupancy rates of commercial properties in central business districts have been heavily impacted, with cities like Melbourne and Sydney reporting occupancies rates of 47% and 61% respectively (as of February 2023, according to Property Council members). This, combined with the sudden rise in interest rates has led to a significant increase in debt servicing costs for these properties. As a result, the valuations of large CBD offices and other commercial properties are expected to decrease in value.
One interesting aspect of this situation is the ownership of these properties and how they are valued. The majority of commercial real estate is owned by Real Estate Investment Trusts (REITs) and Industry Superannuation funds, which means that millions of Australians own a share of these properties through their super. Industry Super funds like owning unlisted property as it can be used to smooth returns and it suits their customer demographic who are contributing to super more than withdrawing.
The valuation of commercial properties is typically based on the sale price from transactions of similar properties, and when the market is rising, there are more transactions that provide opportunities to update valuations. However, in a falling market, there are fewer sales, which makes it harder to correctly value the properties and creates a lag in devaluing their worth.
The lag in declining valuations can feed into a funds return figures and can give the perception of better returns. This is often referred to as return smoothing and also known as to “extend and pretend.”
As reported in the Australian Financial Review (AFR) on 11 April 2023, some of Australia’s biggest Industry Super funds have significant holdings in unlisted property, with Cbus, Rest Super, and Australian Retirement Trust holding 12%, 9.2%, and 8.5% of their total MySuper investments in unlisted property, respectively. The AFR also reported how Rest Super pulled a Melbourne office building off the market after receiving offers 15% lower than their recorded book value. This has prevented the revaluation of that building and similar properties owned by other REITs and Industry Superannuation funds.
This issue is becoming more problematic than during previous cycles as we are about to enter structural changes caused by the pandemic and rapid interest rate increases. The Australian Prudential Regulation Authority (APRA) has become nervous about this and is urging REITs and Industry Superannuation funds to revalue their assets to better reflect the current market conditions.
Listed REITs, which also own property directly and value their properties with the same technique are interesting as they can reflect the market sentiment by their share price falling. When their share price falls but the property assets values haven’t this is referred to as trading at a discount.
When comparing a property fund returns from a super fund using a high proportion of unlisted assets to a super fund investing in only listed assets you might see a large variance. Without naming names, to the 28 February 2023 one super fund’s property option (50% unlisted / 50% Global REITs) has returned approximately -3% for the year compared to various listed property funds returning circa -6% for Australian REITs and -15% in Global REITs.
The problem is that the better returns of one fund over another can lead to misinformed investment decisions when really the driver of that out performance is not better management but just a lag in valuing of assets prices.
If new investors buy units in a fund at a unit price based on asset values higher than the true market value, then they are likely catching a falling knife. Conversely, investors selling units in the same fund are leaving the remaining investors holding the bag.
