Product road test – Centuria’s ‘10 Spring Street Fund’

Co-founder of the Switzer Report
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While unlisted property funds copped a hammering in the wake of the GFC, they now seem to be making a bit of a comeback. These funds tend to be for a single property, come with a plan to improve the property, and importantly, have a defined exit strategy.

The market is being pitched at higher net worth SMSFs and investors, who can afford to lock away the money for the six to eight years it will take before the fund is liquidated. As the funds are geared, tax advantaged yields of around 8% to 9% per annum are forecast, which, in this yield-hungry world, makes them seen pretty attractive.

Active managers in this area include Cromwell Property Group, GDI Property Group and Centuria Property Funds. In this road test, we take a look at a fund that is just about to come to market – Centuria’s fund for 10 Spring Street, Sydney.

10 Spring Street

10 Spring Street is an A-grade commercial office building in the heart of Sydney’s financial district. Built in 1977, the building of 14,000 square metres has 13,000 square metres of office space over 14 levels, and around 1,000 square metres of ground floor retail space fronting both Spring and O’Connell Streets. It also has 47 car spaces.

The fund

The Centuria 10 Spring Street Fund is acquiring the property for $91.6 million. This represents a yield of 6.84% on the property’s passing income (it is currently 81% leased), and 8.64% if it was fully leased.

With acquisition costs of $9.1 million (including stamp duty of $5.0 million), total costs are $100.7m. This will be funded as follows:

Cash invested by subscribers (unit holders): $59.5m

Borrowings: $41.2m

On the acquisition price of $91.6m, the fund will initially be geared at 45%.

Income returns

Forecast income returns to unit holders are:

2013/14: 8.00% pa
2014/15: 8.10% pa

These returns will be tax advantaged to the extent of an expected 100% tax deferral in year one and 73% in year two. For an SMSF in accumulation, this means that this proportion of the income will not be assessable for tax (although the cost base will be adjusted by any tax deferred component).

Investment rationale

The investment rationale for the acquisition is based on the following drivers:

  • the yield gap between prime Sydney CBD office buildings and the 10-year bond yield (the so-called risk free rate) has widened – and is now showing signs of improvement – making Sydney CBD offices still relatively cheap;
  • this building is cheap relative to its peers;
  • opportunity to add value via leasing and positive rental reversion;
  • opportunity to add value through refurbishment of the foyer and repositioning of the retail space; and
  • future redevelopment potential.

Exit strategy

The manager expects the fund to be wound up within 5.5 years in 2018/19 (by selling the property). They say that this will be the optimal time to sell the property – allowing time for yield compression (closing of the yield gap) and its positioning against its peers – as well as time for the benefits of an improved leasing profile and the refurbishment and retail repositioning to be evident in the actual rents achieved.

Unit holders will need to approve any sale. Under the deed, they can vote (by simple majority) to extend the term by a further two years. After that, a further extension will require all unit holders to approve.

Fees

There are two main fees to the manager – an initial acquisition fee of 2.0% of the property’s cost ($1.8 million) to cover the costs of identifying the property and developing the fund, and on ongoing management fee of 0.80% per annum and expense recoveries of 0.28% per annum. These fees are based on the gross assets of the fund – on the net asset value of the fund, it translates to around 1.86% per annum.

The fund manager may also earn a performance fee of 20% of the portion of outperformance of the fund over an internal rate of return (IRR) of 10% per annum. The IRR is a calculation that looks at all the cash flows (purchase price, distributions, sale price), and effectively gives the annualised compound return on the initial investment. Under ASIC guidelines, the fund’s product disclosure statement (PDS) can’t disclose the forecast internal rate of return – the performance fee threshold above provides some clues.

About the manager

Centuria Property Funds is part of Centuria Capital Limited, which is listed on the ASX under code CNI. Centuria has approximately $1.08 billion under management, in 29 unlisted funds covering 50 buildings. They claim an average occupancy rate across their office buildings of 97%.

In terms of track record, Centuria says they have completed 17 funds of over $300 million (established and then liquidated), with an average return to investors of 17.1% per annum.

On the plus side

Despite Barangaroo coming on in the next few years, of all the commercial office markets, Sydney CBD probably looks the best. The building’s current occupancy rate of 81% compares with a Sydney CBD rate of 92.8% – suggesting there is considerable room to improve the building’s return. The manager’s plan to reposition the retail space looks sound (and sorely needed, judging by our quick walk through last week).

While we don’t normally like internally geared funds, with the manager forecasting that they can lock in term funds at a cost of 5.2%, we understand that this is the best way to drive the yield for investors. The forecast return of 8.0% per annum (potentially tax advantaged) is attractive.

On the minus side

Unfortunately, the minimum investment of $100,000 puts this outside the reach of many funds. And, while the performance fee is a “plus”, we would like to see the manager have even more skin in the game and trade-off lower management fees for a higher performance share.

Bottom line

If your fund is at least $1.0m in size and you have limited or no exposure to commercial property, and have the patience to wait five to eight years to get your funds back, this offer is worth considering. Of course, please read the PDS carefully.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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