Getting paid on the amount of assets managed, inflated by bank borrowings, was a common feature of the split-capital investment trust structure. It is one that still exists today although mainly in property trusts.
Listed direct property funds, generally in the offshore sector, tend to base their management fees on total assets, including borrowings.
As a sector, property trusts can feature quite high gearing levels in the neighbourhood of 100 per cent compared with 20 per cent for most equity trusts. By being paid on the total assets, a manager’s fee is boosted substantially by the amount of borrowing in the fund.
There is an issue of potential conflicts of interest in such a structure, as what motivation would such a manager have in reducing debt when it would directly impact on remuneration?
However, while such an argument might hold true for mainstream trust structures using such a calculation, the world of direct property trusts is so vastly different that there appears to be justification for what looks to be an inherent conflict of interest. What it does not do, though, is make property investing or investment trusts any easier to understand, making investors’ job that much more difficult when examining this asset class.
Gearing levels in such funds are not used in the same manner as in equity trusts, nor are they calculated and/or published using the same methodology. In a mainstream investment company, gearing is typically used to gain extra exposure to the market which can boost returns in a bull market but also hamper returns in a bear environment. Borrowing or debt within a property trust can be used for a myriad of different objectives from funding a new development or to pay for servicing of existing properties.
Association of Investment Companies deputy director general Ian Sayers says: “Property trusts are not as homogeneous a group as, say, blue-chip equity funds. They will be doing different things for different reasons.”
According to one of the groups which does charge fees based on total assets, gearing within such a trust is not typically done as a tactical market call as it can be in equity trusts. The use is more within the management of the portfolio, from the physicality of buying and selling holdings to dealing with rental streams and lease renewals.
Data on mainstream equity trusts shows an average gearing level of around 11 per cent at the end of May. Yet Iimia’s Nick Greenwood notes that investment trust analyst Close Wins put the average gearing level of 10 UK direct property trusts at 48 per cent, with the highest at 89 and lowest at 24 per cent, as at August 17. At the same time, the seven European direct property trusts showed an average level of 43.
However, one of the groups within that space, which did not wish to be quoted, claims of the Guernsey/Jersey-listed property trust universe that four have gearing levels under 20 per cent. So why the huge difference in published figures?
Within property trusts, gearing is calculated as a percentage of the assets managed, meaning if there was 100 per cent in property with 20 per cent in borrowings, then the level of gearing would be calculated as 20 divided by 100. This compares with the more traditional method of calculating gearing which is simply to take gross assets over net – in this case 100 divided by 80, giving a gearing level of 25 per cent, higher than the previous calculation.
This is the same scenario or methodology in terms of remuneration where the management fees are levied on total rather than actual net assets. The argument for fees to be paid in this manner comes down to the fact that managing a direct property takes greater time, expertise and resource.
Sayers notes that there is more to managing bricks and mortar than an equity portfolio, from developing to managing the under-lying holdings, all of which can incur costs. In addition, the bigger the portfolio, the more there is to do, whereas the correlation between size and the amount of work that needs to be done to manage the portfolio is not necessarily as strong within equity trusts.
Greenwood comments that while debt within property trusts is far higher than you would see in an ordinary trust, they also tend to be more static due to the differences in the way debt is used within such structures.
The levying of fees on gross assets has been severely tainted by its usage in split-caps and today the evidence would suggest that the majority of conventional trusts do not operate under such a structure. Greenwood says: “It is a conflict of interest that people are far more aware of today so it is more difficult for a trust to get away with. Investment trust boards are far more aware of the implications and, as such, new funds today charge on net assets.”
The main exception to this appears to be bricks and mortar property trusts. Whether or not you agree with the argument over why extra money is needed in managing a direct property portfolio, the difference needs to be highlighted more clearly, as does the difference in the way bank borrowings are used within such portfolios and the manner in which this is presented.
Property investing is complicated enough these days with the ever widening range of vehicles accessible to investors. Having a clear understanding of how fees are charged and how these funds are structured may go a long way in engendering greater trust in them as investments.