Is now a good time to consider residential real estate funds?

Australian investors are well versed in the long list of ways to invest in commercial property. This explains why the commercial property investment sector is so large. The value of unlisted property trusts is estimated at $227 billion, while the listed property trust sector is valued at $144 billion (Property Council of Australia). Despite the commercial property sector’s fund raising success, few investors are aware of the emerging options to invest in funds in the residential real estate sector.

Read on to learn why this emerging investment class is gaining traction and whether now is a good time to consider investing.

Change is afoot in the residential real estate investment universe

The name of the change afoot in the residential real estate universe is equitisation.

Equitisation is when a fund invests in a portfolio of properties and the non-debt ownership is split between the fund’s equity investors. It’s been the name of the game in commercial property for decades, and has enabled the significant listed and unlisted fund inflows the sector has attracted.

Residential real estate has been slower to the equitisation party. However, there are a number of emerging managers with unlisted residential real estate funds up and running who are aiming to change that. These players have good reason to be optimistic. For an asset class which has historically required a significant amount of management effort per dollar invested to deal with setting up loans and managing tenants, the concept of large-scale passive residential real estate vehicles could open up the asset class to a much wider group of investors.

As with all investment opportunities, savvy investors will be assessing the growing list of residential real estate funds in terms of the expected returns on offer versus the risk involved.

The big carrot: solid residential real estate investment returns

According to Russell Investment’s Long-Term Investing Report, the total gross return from residential property between 1995 and 2015 was 10.5% p.a. That’s a big tick for most investors. Residential real estate’s track record of generating solid long term investment returns rivals most asset classes for the compelling reason that land is a scarce resource and the population is growing.

Of course, there are ups and downs over the long term and we’re in the midst of a downturn right now. Market conditions have been weaker in recent months as rising interest rates have taken their toll on credit availability and mortgage serviceability.

According to CoreLogic, Australian property values fell 5.3% on average in 2022 despite a 14.6% increase in average rentals. Both these trends have continued during the first few months of 2023 with most forecasters expecting property price weakness to continue until the RBA pauses its rate rising cycle.

With property values and rentals heading in opposite directions, gross yields are on the rise. The key point for investors to remember is that there’s a connection between the property and rental markets over the long term as higher gross yields tend to drive higher property values. However, in the short term the two markets have their own distinct drivers. Property prices are largely driven by interest rates and the ease of securing a home loan, while the cost of renting depends on the supply of rentals compared to demand.

Right now, the rental market remains critically undersupplied which suggests rentals could continue increasing. Conversely, the property market continues to face headwinds in the form of higher interest rates and credit restrictions.

A unique risk to be aware of before investing in unlisted residential real estate funds

Beyond the risk of a prolonged property market correction, arguably the most significant risk of investing in an unlisted residential property fund is the accuracy of the Net Asset Value (NAV) at the time of investment.

This is a noteworthy risk because the NAVs of unlisted property funds are infamous for being out of line with current market valuations. While these NAV calculations are meant to be completed by external experts with reference to current market conditions, many unlisted commercial property funds only revalue their NAVs when the move is upwards. This practice shows how arbitrary the revaluation process can be and why unlisted property fund investors should be focused on this risk.

As a general rule, if the NAV of the residential real estate fund you’re considering investing in consistently increases on a monthly basis with little or no correlation to broader property market movements, it warrants caution. In this situation, there’s a risk you’re being asked to overpay to invest in the unlisted fund.

Is now a good time to consider investing in a residential real estate fund?

Assuming you’ve found a residential real estate fund which ticks your investment boxes, is now a good time to consider investing? Interest rates are the key to answering this question. If the RBA pauses its rate rises in the coming few months as most market forecasters expect, investors are likely to take advantage of the higher gross yields on offer by returning to the residential real estate market in force. If and when that happens, higher rentals and rebounding net immigration numbers are likely to add further impetus to the next residential property bull market move. So while the exact timing of the next market rebound is hard to predict, current property price weakness could well be an opportunity in the making for long term residential real estate fund investors.

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.