Rising interest rates threaten the excellent performance of real estate funds

Kevin Prosser, head of direct assets research at Lonsec, an investment and ratings group, says overall leverage is “reasonable” at 40-45% of assets under management.

A high debt-to-equity ratio means that a trust has a higher ratio of debt to equity. A low debt ratio means the trust has a small proportion of debt to equity.

Prosser says managers are aware of the potential impact and many have hedged against risk for up to three years, fixed rates with their lenders or are looking at potentially vulnerable variable costs.

More recent construction projects

Potential problems will likely stem from recently launched funds involved in construction projects that may not have covered their borrowings and are facing rising costs or disruption due to shortages in the construction sector, according to the analysts.

It is estimated that there are around 600 unlisted real estate funds with assets totaling around $20 billion, says Zenith’s senior investment analyst Dan Cave.

It is estimated that at least 30 funds have been launched in the past 18 months with assets totaling some $3 billion. These include around 12 office funds, five retail and four industrial, with the rest being a mix of sectors.

Listed real estate trusts and unlisted funds are similar in that investors contribute capital for a share of the assets either in shares (for listed) or units (for unlisted).

Investors receive income (called distributions) and, if the value of the assets increases, a capital gain on their initial investment from either the rise in the share price (for listed companies) or from the sale of the asset (for unlisted).

Listed funds typically yield 3-6% and unlisted funds around 6-8% (the premium is due to the fact that there is little or no cash).


Analysis from the Property Funds Association shows that unlisted funds have rebounded from the pandemic, helped by low rates, economic growth and a recovery in corporate earnings.

Performance was supported by sustained rental income which was boosted by the recovery of rental income from assets that had been impacted by the COVID-19 related lockdown.

Soaring real estate prices for industrial and logistics properties, particularly warehouses, more than doubled total returns to around 30%.

Prime industrial rents are expected to rise around 11% this year (more than double the growth in 2021) and continue to rise at double-digit rates over the next three years as the e-commerce boom makes increase demand for warehouse space, analysis by CBRE and JLL shows.

Total office returns nearly doubled to more than 9% as employees returned to work as shutdowns eased.

Watch rates rise

Retail, which had fallen more than 10% during the pandemic, rebounded to post 6% growth.

Strong price growth means cap rates (a key metric for investors calculated by dividing net operating income by property value) are at historic lows for most markets, as indicated the attached graph.

Investment adviser Alex Jamieson, founder of AJ Financial Planning, said investors need to consider the impact of rising interest rates, especially for aggressively-adjusted funds involved in building projects under pressure from soaring costs.

Analysts say interest rate increases are expected to be rolled out over the next couple of years and for many funds the impact could be offset by the recovery in earnings as the economy strengthens.

For example, higher wages could be inflationary, but could stimulate demand for retail assets as retail spending by low- and middle-income people increases.

But Zenith’s Higgins said: “We think many funds are high risk propositions considering that we are likely to be emerging from a high growth environment and entering a period where easy gains from rising markets will be more difficult to obtain. ”

Higgins thinks many smaller operators underestimate the challenges and costs involved in achieving the higher sustainability standards required by tenants and potential future buyers.

“We are essentially at a point where any company or fund that cannot demonstrate strong environmental, social and governance credentials, which naturally cover a wide range of sustainability and social issues, will simply be ‘uninvestable’ for institutional investors. “, did he declare.

“We know from experience that many companies with fewer resources to devote to these disciplines are increasingly at risk of being locked out by capital markets that demand greater transparency on how these issues are handled. These views are likely to increasingly reverberate with retail investors as scrutiny of these issues intensifies.

What to check

Ten questions an investor should consider before investing in a real estate fund include:

  1. What are the age, quality and location of the assets of the trust? Do the assets have strong rental commitments and long-term leases? Are they well positioned and do they have quality cash flows?
  2. What is the expiry date of the leases, what is the vacancy rate?
  3. How will the fund pay for capital improvements or acquisitions?
  4. What is the market outlook? Is demand for assets improving?
  5. What is the fund’s borrowing or indebtedness? High leverage increases risks in the event of a market downturn.
  6. What are the fees? Are they transparent? Is the performance fee based on a reasonable threshold? Are there additional fees for raising debt or are they included in the management fee?
  7. Does the manager have a solid track record?
  8. Beware of complicated financial structures as they increase risk, reduce clarity and add expense.
  9. Make sure you get regular updates on the funds’ performance, assets and strategy to critically assess their management.
  10. Does management follow its stated investment strategy?