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Offers of Unlisted Interests in Commercial Properties - A Review

2. THE NATURE OF COMMERCIAL PROPERTY INVESTMENT

2.1

Although the structure of commercial property investment has evolved over the years, the common form in recent market issues has generally comprised the following:

The issuer, a property-owning company, purchases and holds one or more commercial property or properties with a single or multiple tenants;
The issuer raises funds from the public by issuing a combination of equity securities and mortgage bonds, described as "stapled" because the subscriber must purchase both equity securities and bonds in a fixed ratio, and with a minimum investment of usually $5,000;
The issuer may also borrow funds on mortgage from a bank via a term loan with terms usually requiring interest payment during the term of the loan and repayment or roll-over of the principal in a lump sum within a few years (sometimes a bridging loan may also be taken out for a short-term of up to 6 months to cover shortfalls in subscriptions);
The equity securities have no termination date, the bonds may have a specified maturity date some distance in the future or repayment may be dependent on the property or properties being sold;
The issuer meets what are usually quite significant preliminary expenses, including costs of arranging the issue, brokerage, a fee paid to the promoter for "finding" the property and legal and valuation expenses;
The issuer receives rental income from the property's or properties' tenants and this cash flow provides the source for the payment of returns to investors;
The promoter, who is usually the manager of the investment, is paid regular management fees for administering the property, including collecting the rent, arranging for new or replacement tenants and arranging building maintenance;
In some cases, promoters also hold promoters' shares (without the requirement to subscribe for the bonds) entitling them to a share of the net assets of the issuer when the investment is terminated;
Final repayment of shares and bonds will not normally occur until the property is finally sold;
In some cases investors' interests may be tradable on an unofficial market run by the promoting company.

2.2

A typical investment (not based on any particular offering) might look something like this:

(a)	Property cost	: $10 million
(b)	Shares and bonds subscribed	: $7.5 million ($1.5m equity, $6m bonds)
(c)	Bank loan	: $3.5 million (to be repaid in 5 years)
(d)	Rental income	: $1 million p.a
(e)	Preliminary expenses	: $1 million
(f)	Interest on bank loan @ 7%	: $245,000 p.a.
(g)	Expenses and fee	: $115,000 p.a.
(h)	Interest to bondholders	: $640,000 p.a. (forecast for 5 years)
(i)	Net deficit in first year	: $1,000,000
(j)	Net surplus for subsequent years	: $0
(k)	Sale price of property	: $10 million (forecast no price increase)

What is the "return" to investors in this typical case?

2.3

For the first 5 years, the investor receives $426.66 cash in hand for every $5,000 invested in shares and bonds (1,000 shares, 4,000 bonds).

2.4

In relation to the $4,000 invested in bonds, $426.66 represents an annual "return" of 10.66% in each of the first five years. This is return type A - interest rate on the bonds.

2.5

In relation to the $5,000 invested in shares and bonds, $426.66 represents an annual "return" of 8.53% in each of the first five years. This is return type B - combined rate of return on bonds and shares.

2.6

If the return is expressed as a cash distribution, the return on the investment would be described as $426.66 per $5,000 investment. This is return type C - dollar value of cash distribution.

2.7

At the beginning of the forecast period, the net tangible asset of the investor is $1.00 per share (equity of $1.5 million divided by 1.5 million shares). At the end of the first forecast period, the net tangible asset of the investor is $0.33 per share (equity of $0.5 million divided by 1.5 million shares) as the value of the issuer's equity would have declined to $0.5 million (opening equity of $1.5 million less net deficit of $1 million). Shares initially costing $1,000 would realise $333.33 at the end of the first forecast period if sold at book value. Adding back the cash payment received of $426.66, the investor's initial $5,000 investment would amount $4,760, a negative return of 4.8% for the first forecast period. This is return type D - interest on the bonds plus change in net tangible assets.

2.8

Another way of measuring the return on an investment is to calculate an "internal rate of return" (IRR). This is the rate required to equate the present value of all cash flows from an investment with the present value of all cash outlays on that investment. Using the investment period of 10 years and assuming:

the property realises its cost price of $10 million at the end of 10 years; and
the bank loan of $3.5 million is renewed at the end of 5 years on the same terms as the initial loan; then, the internal rate of return for this project would be about 7.5% p.a.³ This is return type E - internal rate of return.

2.9

A further measure of a property's ability to produce "returns" is that of rental yield. In this instance the property produces rental income of $1 million per annum on a property costing $10 million. This is a rental yield of 10% per annum. This is return type F - rental yield.

2.10

As illustrated above, the "rate of return" to investors that is stated in an offer document by a promoter can vary depending on the method and assumptions used to calculate the returns and whether these returns relate to the short or long-term.

Risk factors and assumptions affecting returns

2.11

Some particular risk factors arise from investment in property, whether directly or indirectly, through commercial property shares and bonds. They include:

Changes in property prices will affect the overall return achieved by the investor over the term of the investment;
Difficulties in tenanting the property, particularly where it is a single tenant investment, can have a marked effect on the continuing cash flow for investors;
If external loan finance has been used to finance part of a property purchase the need to refinance the loan could affect the cash available for investors, particularly if refinancing cannot be arranged or is renewed on less favourable terms than the original loan;
Preliminary expenses, ongoing management fees and profit sharing arrangements with promoters could impact significantly on the returns available to investors;
Although unlisted, many promoting companies provide an informal market for investors to trade their securities. The market for stapled property securities may be illiquid and, if investors need their funds early on in the life of an investment they may suffer significant losses if they attempt to sell their interests;
There could be some corporate risk if the investment vehicle is a company. The directors of the company may have the ability to use the company's funds for investment outside the particular properties owned by the issuer.

2.12

It is apparent that the assumptions made by a promoter concerning property values, ability to keep a property fully tenanted, ability to roll-over external finance and economic conditions generally will have a significant effect on any promised, forecast or projected returns from a property investment being offered to the public.

3	@7%	@8%
Initial outlay by investor	: $7,500,000	$7,500,000
Years 1-10 interest @$640,000 pa	: $4,294,400	$4,495,400
Year 10 net residual value (Sale of property less bank loan) $6,500,000
	: $3,009,500	$3,302,000
return	$7,303,900	$7,797,400

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