Income in A-REITs is the essential attribute of property investment

Income from a property investment is generated through the receipt of growing rent secured by a lease contract. The variability of income is low. Earnings in Australian real estate investment trusts from additional sources, including property development and funds management, dilute this stability. 

Property income exposure within an A-REIT portfolio can be enhanced by selecting those A-REITs that reflect these characteristics of property. Up until the onset of the GFC, the use of gearing increased reflecting the relatively low cost and ready availability of debt. This exacerbated the steep rise and subsequent decline in market capitalisation of A-REITs. 

In the four years leading up to December 2007, average A-REIT price performance of 9.1%  per annum reflected using increased leverage, acquiring overseas properties and higher valuations on fund management businesses. In the four years to December 2011, the average price fell by 22.5% per annum. By contrast, the average annual income return for the four years to December 2007 was 6.6% per annum compared with 7.1% per annum for the subsequent four years to December 2011. 

Not only was there a stark contrast in performance, volatility increased significantly as market prices and sentiment deteriorated. The magnifying impact of excessive gearing was evident in performance between the two periods. Volatility of return increased from 11.6% per year in the four years to December 2007 to 33.1% per year in the four years to December 2011. Annual volatility of income returns decreased from 3.5% per year to 2.6% per year between the same two periods. 

The income generated by property is relatively stable. The introduction of alternative sources of income including development profit, transaction and fund management fees shifted the characteristics of an A-REIT investment away from property fundamentals and increase volatility of returns. By focusing on contracted rental income, the business risks and associated volatility of return of the investment can be reduced. Imprudent gearing will magnify volatility of earnings and returns.

Mark Wist is senior asset consultant at Atchison Consultants.