Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 154

How do unlisted real estate funds generate high income returns?

In Part 1 last week, we looked at the characteristics of unlisted property funds (syndicates) that investors should look for. In Part 2 this week, we look at how the returns are generated.

Many investors must look at an unlisted real estate fund’s yield at say 7.3%, on a property acquired with income yield of say 7%, and wonder where the money comes from. The answer is leverage and cost of debt. Whilst a syndicate’s yield is a function of the net income that the underlying property generates, the ultimate yield to investors depends on the gearing level and borrowing costs.

Higher gearing enhances the yield if the cost of debt is below the yield of the asset, as in the current market. We advocate gearing not to exceed 50% and start with at least a 10% buffer to the bank’s loan to value (LTV) covenant, usually 60%. This buffer is in case asset values fall.

Table 1 shows an example of an asset generating a net income of $3 million per year and purchased on a yield of 7.0%. Let’s assume that it is fully tenanted and relatively new so the capital expenditure requirements are minimal. There are three scenarios – the asset has leverage of 40%, 50% or 60% and the acquisition costs are not capitalised.


The distribution yield varies between 6.1% and 7.31% depending on gearing.

The cost of debt also has an impact. Table 2 shows the impact under two other scenarios related to the cost of debt. Firstly, the manager secures debt at 3.75% (assume a 90 day BBSY base rate of 2.3% and a bank margin of 1.5%), which is highly possible in today’s low interest rate environment and secondly, interest rates move back closer to long-term levels and debt is secured at 6.5% (a base rate of 5.0% and a margin of 1.5%).

Gearing enhances returns

There is a wide variation in a fund’s yield based on the gearing levels and cost of debt.

Leveraging up in a market when asset prices are rising (yields are falling) and debt costs are low, as the table above shows, can generate supersized returns. However, the risk in those funds is significantly heightened when the cost of debt goes up or the real estate cycle turns and prices fall as it inevitably will at some point. Investors need to understand that prudent use of leverage, with appropriate capital management strategies (covenant levels, type of debt, principal and interest or interest only, duration of debt (short or long term) and hedging) can be an effective financial instrument. Abused, the ramifications can be significant.

As real estate yields have fallen, it is pleasing most managers of recent unlisted fund offers are avoiding the temptation of leveraging up to boost a fund’s yield. Managers and investors must remain diligent as real estate yields head to cyclical lows, and avoid the temptation. As Warren Buffet said “when you combine leverage and ignorance, you get some pretty interesting results”.

Exit strategies, liquidity and term extensions

We are often asked what happens at the end of the syndicate's term? What happens if an investor needs liquidity? Why does the syndicate require such high thresholds to rollover for a longer term? These are all legitimate questions which managers need to clearly articulate to investors.

Unlisted real estate fund is a long-term investment. If investors are concerned about short-term liquidity needs they should consider investing in listed real estate. There are times when a person’s circumstances change due to death or divorce and they wish to liquidate the investment.

In a syndicate, the only way this can be dealt with is via an off-market trade in which another investor is willing to buy their units in the fund. There is no secondary market for trading of units although there are some funds that have been established to acquire units from investors, and from time to time, the manager may be approached by other investors who may wish to invest in the fund. The manager may put the two investors in touch with each other to negotiate an appropriate price but the manager is legally not able to create a secondary market in trading the units of its fund.

The GFC highlighted the inadequacy of many unlisted funds whereby they did not focus on the exit strategy which created a misalignment between investors and managers. A number of funds were extended for a further term prior to the GFC and then took a hit as the market collapsed. In effect, some managers ‘rolled the dice’ and kept their funds running beyond the initial term. This allowed the managers to collect fees for longer when asset pricing started to reach excessive levels and the funds had already delivered strong returns to investors.

Most of the leading managers now use structures that require unitholders to vote to amend the fund term and performance fee structures. They incentivise the manager to recommend to unitholders to wind-up the fund early if they believe the returns from the asset have been maximised or the cycle is nearing the peak. Managers have also inserted early wind-up provisions into the terms of the fund typically based on a Special Resolution ie at least 75% of votes cast by unitholders on the resolution to be in favour of the resolution for it to be passed.

The Special Resolution provision should also apply if the manager believes it is in the best interest of investors to extend the term of the fund. This may arise as the property has an upcoming lease which if renewed or extended can add value to the fund if the sale is delayed until this is actioned, or it could be that the market is soft and liquidating the asset at the time may not optimise the return to investors.

The key with exit strategies is for the investor to recognise that investing in an unlisted fund is long term and the manager’s role is to optimise the value of the asset and the return to unitholders which may mean, in certain circumstances, winding-up early or extending the life of the fund. The decision should be relatively straightforward for both the manager and investor if there is an alignment of interests (see Part 1 last week) and there is an appropriate voting mechanism that gives investors a say in what happens.

 

Adrian Harrington is Head of Funds Management at Folkestone (ASX:FLK). This article is general information and does not address the specific investment needs of any individual.

 

RELATED ARTICLES

What to look for in unlisted real estate funds

The hot spots in commercial real estate

Real estate outlook: positive returns expected in challenging year

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.