Investors take huge hit in property syndicate

Property

Property syndicate suffers huge loss in value, investors to stump up with additional cash to fix problems

19th Jan 16, 9:44am by Greg Ninness

By Greg Ninness

Property syndications are very much in vogue with investors at the moment. This is because the larger commercial properties that tend to underpin them are seen as being less price volatile than shares in listed companies, and the regular income streams they can provide are generally higher than those currently available from bank deposits and residential property investments.

However they are not immune to risk and this can sometimes manifest itself in unusual and unexpected ways.

One property syndicate which has struck financial difficulties and is currently being recapitalised is the Eagle Technology Proportionate Ownership Scheme.

The scheme owns Eagle Technology House, an 11 level office building with ground floor retail premises and 33 on-site car parks located on Victoria St in Wellington's CBD.

The property was acquired for $23.8 million and put into syndicated ownership by Oyster Group in 2009, with investors taking up 143 interests at $100,000 each with the remainder of the purchase price and the scheme's set up costs funded by an interest-only mortgage from BNZ.

Oyster chef executive Mark Schiele said the scheme was originally paying investors a return of around 10% a year. But following the 2011 Christchurch earthquakes its insurance premium rose massively from around $100,000 a year to $250,000 immediately after the quakes, and then $400,000 the following year and that hit the scheme's cash flow, although the insurance costs have since fallen back to around $150,000 a year.

Then in 2013 Wellington had two significant earthquakes of its own, the first of which did no damage to the building but the second damaged its stairs and the scheme had to spend about $400,000 on repairs.

But worse was to come.

After the Wellington quakes seismic strength issues became top of mind for many tenants and the Eagle building had a seismic rating of 50-60% of New Building Standard, which was unacceptable to many tenants.

As leases in the building expired they were not renewed and it became difficult to attract new tenants.

Vacancies rise, equity tanks 74%

The building's vacancy rate increased to 55% which saw rental income slide from $2.173 million in 2010 to $1.415 million last year, and that fed into lower valuations for the building, with the latest valuation coming in at $15.4 million, down 35% from its 2009 purchase price.

It also caused severe cash flow difficulties and the scheme's investors have seen their equity decline from $11.9 million in 2010 to $3.1 million last year and in the year to March 2015 it posted a loss of $3.3 million, distributions to investors had dried up, the scheme was in breach of its banking covenants and the auditors suggested it could no longer be considered a going concern.

Clearly something had to be done.

Investors could have sold the building, wound the scheme up and taken the loss on the chin, but instead have decided to recapitalise and tip in enough additional money to have the building seismically strengthened to 80% of New Building Standard.

That should in turn allow the vacant space to be leased, which would lift rental income that should start to flow through to rising capital value, putting the scheme back on the road towards financial health.

The plan will require investors to contribute an extra $18,000 per existing $100,000 interest, which will be achieved by issuing B shares to the existing investors.

Schiele said existing investors did not have to take up the B shares if they did not want to but indications were that others would take up more than their pro-rata allocation and it was envisaged that all of the money required would be raised from within the pool of existing investors and the seismic strengthening work would be completed within the first half of this year.

Some risks associated with property investment are obvious, such as the potential for a rise in interest rates, the loss of a key tenant or generally weakening market conditions

Others are less obvious and much harder for investors to quantify when considering a potential property investment.

But as the difficulties encountered by the Eagle scheme show, the risks are real and investors should always be prepared for the possibility that an investment could unexpectedly suffer a sharp reversal of fortune and they could end up having to choose between taking a substantial loss or stumping up with additional cash to fix the problem.

Click on this link for a general guide to how property syndication works.

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19 Comments

by Uninterested | 19th Jan 16, 10:02am 1453150925

No diversity in this "investment".
Some times it may be best to demolish and start again...

by Keyser Söze | 19th Jan 16, 10:37am 1453153053

David - any inside on when REINZ stats come out? They are taking forever!

by Simon | 19th Jan 16, 11:37am 1453156641

This afternoon ive been told

by Keyser Söze | 19th Jan 16, 12:54pm 1453161246

I bet it don't - wonder why they are dragging their feet.....

by dtcarter | 19th Jan 16, 1:13pm 1453162436

Because they and half the agents have been on holiday?

by waymad | 19th Jan 16, 10:38am 1453153089

To investors fed on a diet of 'Property is rock solid', 'Prices always go oopards', and similar memes, this will be a shock. To older, wiser investors, this is the start of the Seven Lean Years....

by Simon | 19th Jan 16, 11:42am 1453156920

only a hit if they sell out at current temporarily low valuation. Property is long term; over time wellington cbd, esp if labour ever get back in, will appreciate while providing a very good yield a long the way

by Boatman | 19th Jan 16, 11:51am 1453157464

New Zealand Property Syndications are DOGS , and should be left well alone .
Here are my reasons

1) The promotors fees are usually enough to retire on ( its legalised robbery )
2) The management contracts usually start with a waived fee ( to push up the yield)
3) The shares are untradeable as there is no secondary market ( zero nil nothing )
4) The management fees are usually slow start , ramping up after a few years , and are contractually binding ( before you invest)
4) There is often debt at low rates with later increases that leave investors exposed to interest rate movements
5) When there are vacancies , the shareholders need to cough up the shortfall to service debt ( and they often cannot do so as they are retirees in Tauranga )
6) Most prospectuses do not show adequate provision for maintenance , this is done to increase the "illustrative yield "
My advice to people wanting property assets is to buy listed property shares , they are a much safer bet

by King of the whiners | 19th Jan 16, 11:58am 1453157902

Very well put, could not agree more. The lack of liquidity is for me the crucial problem, particularly with what is coming.....

by Greg Ninness | 19th Jan 16, 1:27pm 1453163273

Property syndicates are not for everyone and there will be plenty of investors who have lost money in them over the years and others who have done very well. But one significant change that has occurred in the last few years is that syndcations are now more highly regulated by the FMA and that has led to some big improvements in the way they are set up and managed and in the information that's made available to investors. Regarding the specific points you have made:

10Promoters' fees and other upfront costs can be high relative to the size of the investment because syndicates are complicated beasts with high set up costs and this can affect NTA. But fees can also vary between offerings and are fully disclosed, so investors need to decide whether the return being offered justifies the fees being charged.

2) I'm not aware of waived fees being an issue in any of the new syndicated offerings I've looked at in the last few years. I suspect this is a legacy issue from older syndicates.

3) The shares or "investor interests" (depending on a syndicate's structure) are unlisted but can be sold privately. This is usually handled by the in-house or agency sales people who sold down the initial offering. At the moment resales are generally selling well and there is a good market for them, for good reason. Yields on good commercial properties have been falling, so a syndicate that was set up a few years ago is likely to be providing a higher return than one that is just coming to market. This makes shares in the older syndicates relatively more attractive than newer ones and gives the seller more room to negotiate on price. However the real test will come when market conditions become less favourable, especially if everyone heads for the exits at once.

4) I'm not aware of low start management fees being a feature of modern syndicates, at least not those promoted by the major syndciation companies. However the fees are often linked to CPI or some other measure, which can be an issue if rents are static or declining.

5)Quite right, but it's the same with all property investments. If you own a residential rental and don't have a tenant for a while you still need to pay the mortgage and the other outgoings. Which is why its important to check out the quality of a property, it's tenant and the terms of the lease before writing the cheque.

6)I suspect this is probably also a legacy issue from some of the older syndicates. But it's something investors shoud think about if the building is older. Some leases require the tenants to pay for regular maintenance.

Syndicated ownership does not remove the risks associated with property investment. Its main advantage is that it allows investors to access the returns available from larger commercial properties without having to buy the whole building themselves.

by Bernard Hickey | 19th Jan 16, 12:04pm 1453158285

Excellent piece Greg. It helps explain why Wellington has struggled so much as a city over the last four years.

by dictator | 19th Jan 16, 6:45pm 1453182323

Even residential body corporates have been hit hard with seismic strengthening. There's a lot of buildings still on the earthquake prone list.

by steven | 19th Jan 16, 9:02pm 1453190542

20 years ago I refused to look at such CBD flats and even told a few ppl it was a bad idea.

by stevell | 19th Jan 16, 1:44pm 1453164276

It will be interesting to see how MyFarm goes with the current dairy downturn - well not them I guess, just the investors that they have milked? (sorry MyFarm - thats a bit mean - but funny if you are not an investor!)
They are now into the kiwifruit space - picking some low hanging fruit!

by Jay99 | 19th Jan 16, 11:33pm 1453199624

Greg - Happy to see you're take a hard look at these property syndicates and helping the public make better informed investment decisions.

A couple factual errors in your comments:

1) A syndicate isn't a particularly complicated or expensive structure to setup, all else equal. The largest component of fees paid to the syndicate promoter is the underwrite fee, which is both out of proportion and unwarranted relative to other investments and the amount of risk actually being undertaken.

2 & 4) Management fees typically increase with CPI, while rents are locked-in reducing the investors returns over time. Further, when the first few years of management fees are paid upfront by the investors (or waived) they are not included in the advertised cash yield, which serves to inflate forecast returns in the first few years.

6) Maintenance capex is not a legacy issue, it is inherent and vital towards the upkeep of any property. Failure to factor this in to any property investment is a mistake, eventually chipping away at the property's value through less attractive releasing prospects, and deceptive to investors as it incorrectly inflates the property's true economic return potential.

Notwithstanding, I believe that your conclusion that these property syndicates contain simple property risk and to caution investors they might be required invest additional capital or suffer a loss, is inadequate.

As both the U.S. and New Zealand experience has shown in prior decades, the syndicate structure is insufficient to provide; investors with diversification from single property (and sometimes single tenant) risk, flexibility and capital to properly manage the asset (including maintenance capex to maintain the rental stream long-term) and liquidity for investors.

One more point on the liquidity issue - experience in the GFC shows liquidity matters most when things go wrong. To be perfectly clear, real estate has historically offered investors superior yields to compensate for the fact that it was not particularly easy, quick or cost effective to sell an investment property. The advent of real estate securitisation (syndicates, funds, REITs) has provided that liquidity which resulted in a compression in property yields (over and above the compression in property yields over the last decade due to falling government bond yields). Anyone who trades away this liquidity without being compensated in significantly higher yields today would be foolish. Resales of syndicate shares or positive valuation markups during good times provides absolutely no mitigation of these risk, as you seem to suggest.

Should the proverbial "property syndicate" building catch fire and everyone head for the doors all at once, I think you'll find the doors were deceptively narrow and many will get burned. I'll be on the outside enjoying the warmth.

by Greg Ninness | 20th Jan 16, 10:06am 1453237567

Hi and thanks for your comments.

I disagree when you say they are not complicated or expensive to set up. The reason is that you need to have a reasonably substantial organisation in place to set these things up, bring them to market and then manage them. And the disadvantage of the current regulatory regime is the high cost involved in issuing a prospectus etc. Syndicates are relatively small investment offerings but they have the same cost structures as much bigger ones. This means they have high upfront costs relative to the size of the investment, which is a drain on their initial NTA. Underwrite fees have been a relatively new development and not all syndicates have an underwrite component, although it's becoming increasingly common. Like you I am not convinced they are always necessary and its something investors should pay greater attention to.

I don't think it's quite correct to say that management fees increase with the CPI while rents are locked in. Leases will usually contain a mechanism to adjust the rent, such as an annual increase, which could be a fixed amount or indexed, and then periodically adjusted to market rates, perhaps with a ratchet clause that stops the rent falling. But it would be good to see a management fee structure that was based, at least in part, on the performance of the investment.

By legacy issue I meant that underestimating maintenance costs was something that may have happened in older syndicates, most of which have probably now been wound up. The newer ones that I see now seem to have a reasonable handle on likely maintenance requirements and will try and push as much of those costs as possible back on to the tenants through net leases. Of course there are always exceptions.

To say that a syndicate doesn't provide diversification is a bit like saying shares in a single company or a bank deposit don't provide diversification. Of course they don't but it is only an issue if you put all, or at least too much of your available investment funds into that single asset. You can achieve diversification simply by spreading your money between syndicates as part of a broader investment strategy which includes other asset classes.

by TuaWai Smith | 20th Jan 16, 1:53pm 1453251182

I've looked at these syndicates in the past and do not like the way they are structured as there is just no control. I guess I am just too conservative and may be giving up some potential short term returns but in the climate of real estate in NZ, specifically Akl,, (not necessarily in Wellington as I don't know this market) I would stay away from ANY real estate right now. I would look for more disappointments in the syndicate future with overpriced crappily constructed buildings, with too bright and flowery a picture painted by the promoters to the extent of stretching the truth. Many have been lucky for a while but...'Investor Beware'. Good luck to them.

by G Langford | 20th Jan 16, 1:54pm 1453251255

The article refers to the Eagle Technology Proportionate Ownership Scheme owning Eagle Technology House. I want to make it clear that this scheme and the building ownership has nothing to do with Eagle Technology Group Limited which is a well established and successful IT company that leases space in the building and has naming rights.

by Property Leader | 18th Feb 16, 1:37pm 1455755828

As the comments indicate this is certainly not an isolated case I know of a number of them in Wellington CBD. What makes this one different is the investors are stumping up with some more money. The one I am stuck with lost 7 floors of tenants, needed one million $ earthquake strengthening plus another million of principle payments to the bank due to building value plunging. We started off at 12% net then have been at zero payments for the last four years. However now fully released, strengthening close to finish and value on the up. Shareholders payments might start again this year. Most of the other shareholders seem to only invest in syndicates and not directly into property like myself. Diversification is a two edged sword. It can cut you to pieces when it falls the wrong way.