Gearing : big returns, big risks

Where does an investor find growth is the question everyone is asking.

Fixed interest is barely above inflation, the stock market just finished the financial year flat and promptly retreated, and while property is still running hard the risk factor is increasing as supply closes on demand and nervous bankers start to restrict credit.

It’s interesting to compare how retail investors are reacting compared to those in the professional ranks, particularly when it comes to use of gearing in the managed property area.

If you remember it was this area that got itself into such a tangle at the end of the last boom with some funds (that survived) only recently completing their buyback programs after freezing investors’ funds in for years.

The danger in these types of funds is a run of liquidations can’t be accommodated because the underlying assets, ie property, are illiquid.

So guess what, they’re back and have been performing quite well as investors search far and wide for better yield. However, there is a vast difference between your average unlisted property trust and the high performance/high risk trust that is provided to institutional and high net worth individual so-called sophisticated investors.

And that difference is gearing. That’s right the mechanism that accelerated massive losses in the last cycle proves to be the catalyst between generating single and double-digit returns. That’s if you have the stomach for it.

Increased investor popularity of property funds and rising competition amongst fund providers is encouraging some managers to highlight the role of high gearing in boosting returns and raising risks.

According the Australian Financial Review, retail investors typically concentrate on unlisted trusts that have less than 20 per cent allocated to riskier new developments, less than 50 per cent gearing and more than 90 per cent exposed to property.

During the past 12 months to the end of May the sector earned a long-term average of 7.5 per cent and capital gains of about 2.5 per cent. These types of funds are found in bigger commercial, office and shopping centre landlord operations. They may all face cost pressures in the next 12 months.

But when it comes to wholesale funds, which typically have higher gearing and riskier assets, their average returns look more like 18 per cent plus, before fees.

Historically low interest rates encourage these managers to go hard with loan-to-valuation ratios down in the 50 per cent-plus range. High gearing can help out-performance in rising markets but it increases the risk of losses in a downturn. Leave it to the professionals.

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