How to determine if the trend is your friend


I was on the hunt for some interesting insights in to the current market and using momentum or contrarian strategies for clients .  Lawrence Lam of Lumenary Investment Management writes in this guest blog that it not always a case of either or but a combination.

At a recent lunch with another fund manager I found myself engaged in a discussion about the state of the current market.

‘From your perspective, are you seeing many good opportunities?’ I asked.

‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong – the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’

I nodded as we both acknowledged this unique investment environment. Decreasing rates, high stock valuations, yet stock prices that have continued to climb steadily.

Walking back to my office I reflected. ‘Is now a good time to be a momentum investor? Or is it time to go against the herd?’

Harness the power of momentum or be a contrarian?

 It’s a dichotomy faced by all investors, but it isn’t a binary decision. Your portfolio can be made up of both momentum and contrarian investments. So the question becomes: how can we determine the optimal proportion of holdings between momentum and contrarian?

Are you seeing the full picture?

Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.

The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).

But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time – over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15 year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.

As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.

 

During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.

Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question…

 

Is the party getting started or is it about to end?

There’s an interesting observation about parties. When do they end?

Answer? They end when the alcohol runs out. Rarely do they end immediately though. Good times roll on for a while longer before the sudden realisation hits the sobering crowd.

So when is the worst time to join a party?

As you’re pondering the answer, here is another view of HEICO to illustrate the point.

 

Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in it’s price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.

Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain – his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.

The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when there crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.

A ‘reasonable’ price

Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.

Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.

But there’s more for enterprising investors – the picture is still not yet complete.

A deeper level of analysis

Competition

You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.

Potential growth

So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.

Intrinsic value

Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.

As Warren Buffett says “Price is what you pay, value is what you get”.

The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.

Closing remarks

Is the trend your friend?

If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.

Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.

Happy compounding.

Note:

Stocks mentioned have been used as examples only. They are not recommendations to buy or sell.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

 

The SMSF Coach is in no way connected to Lawrence Lam of Lumenary Investment Management and we do not receive referral fees or commissions of any sort from them. This is purely general advice and market commentary from a trusted source and you should seek personalised financial advice before making any investment decision.

Looking for an adviser that will keep you up to date and provide guidance and tips like in this blog? Then why now contact me at our Castle Hill or Windsor office in Northwest Sydney to arrange a one on one consultation. Just click the Schedule Now button up on the left to find the appointment options. Do it! Make 2019 the year to get organised or it will be 2029 before you know it.

Please consider passing on this article to family or friends. Pay it forward!

Liam Shorte B.Bus SSA™ AFP

Financial Planner & SMSF Specialist Advisor™

SMSF Specialist Adviser 

 Follow SMSFCoach on Twitter Liam Shorte on Linkedin NextGen Wealth on Facebook   

Verante Financial Planning

Tel: 02 98941844, Mobile: 0413 936 299

PO Box 6002 BHBC, Baulkham Hills NSW 2153

5/15 Terminus St. Castle Hill NSW 2154

Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572

This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

 

Why you should make loans to your children not gift them money


I am always on the look out for interesting tips for clients and while this may not necessarily be SMSF related, many of my readers are also wish to help their children with money for house deposits, education funds or other ad-hoc expenses .  I read the blogs from Dr. Brett Davies at Legal Consolidated regularly and found them very informative and excellent guidance so, with his permission, I am “paying it forward” again!

In his blog Parents making loans to children he discusses why smart parents use loan agreements to protect the family wealth. Here is the detailed article and video he prepared.

Parents making loans to children

Sad parents

Mum and dad give their daughter, Joanne $400,000 to buy a house. She then marries Ken. Ten years later Joanne and Ken divorce. The house is still worth $400,000. It is the only asset of the marriage. The Family Court awards $200,000 to Ken. The Family Court is not interested that the money was a gift from Joanne’s mum and dad. Instead, loans to children are safer.

Smart parents

Mum and dad lend $400,000 to their daughter, Joanne. Joanne signs a legally prepared Loan Agreement built on Legal Consolidated’s website. Joanne purchases a house with the money. She marries Ken. Ten years later they divorce. The house is still worth $400,000. It is the only asset. The Family Court is shown the Loan Agreement. The Family Court orders that Ken gets nothing. This is because the assets of the marriage are nil.

To protect your loan build a legally prepared Loan Agreement – on a law firm’s website. Homemade loan agreements may not work. They carry less weight with the Family Court and Bankruptcy Court. Why take the risk?

But I love my children

There is nothing wrong with helping our children financially. It could be for their first car, grandchildren school fees, a holiday or a property. Today it is becoming more popular to help out our children with a home deposit, but simply giving away the money has real risks. It is important to protect the money in case:

  1. they divorce
  2. go bankrupt

  3. suffer from drugs
  4. suffer a mental condition
  5. stop loving you – ‘King Lear’ offers his daughters his Kingdom for the return of their love, but after they promptly abandon him
  6. you run out of money yourself, in your old age

loans to children

 

Documenting loans to children

Never ‘give’ your children money. Always ‘lend’ them money ‘payable on demand’. Get it back if something goes wrong. Treat yourself like you are a bank, and your children are taking out a loan.

Creating a loan agreement not only protects your own interests but also benefits the child as you can decide in the future to forgive the loan while you are alive or in your Will.

With loans to children, never rely on a verbal agreement. Press the Build button and build a Loan Agreement on our website. We are Australia’s only law firm website providing legal documents online. It puts everything in writing with rules about the loan.

Any tax issues?

There are no tax issues. The interest rate for the loan is ‘as advised by the Lender’. Therefore, while the interest rate is zero you have no income tax issues. If the child separates you can increase the interest rate to draw more money out of the failed relationship. There is less money for the Family Court to give to your ex-in-law.

A loan isn’t always for property and the grandchildren’s school fees. You can also fund the children’s Superannuation fund. Speak to your Financial Planner and Accountant.

At different times, it is common to benefit one child over another with money. If you benefit one child over another then it is adjusted automatically at the time of your death. Say you lend one child $500k and the other child $300k then that is adjusted at your death. So it is all fair again.

When making loans to children:

  1. talk with all your children together about the loans
  2. never gift children money – only loan them money (this protects both you and them).
  • don’t rely on home-made loans or IOUs – build a Loan Agreement

  •  

    loan agreement legal consolidated brett davies lawyers

    Can I just do a Loan Agreement on the back of an envelope?

    In the movies, IOUs are often handwritten on a piece of paper. Sometimes instead of a Loan Agreement, someone does a ‘minute’. Both approaches fail. In Rowntree v FCT [2018] FCA 182 shows the additional care required to document even simple related-party transactions, such as loans. In this case, the taxpayer, a practising NSW lawyer, claimed he borrowed over $4m from his group of private companies. The Court said:

    ‘Mr Rowntree has not deliberately chosen to ignore the law. His evidence presented to the Tribunal suggests that he genuinely believed that there were arguments to support his view that a loan was in existence.’

    He failed. Only a legally prepared Loan Agreement satisfies the ATO, Bankruptcy Courts and Family Court.

    Cheeky son refuses to pay Dad back

    In Berghan v Berghan [2017] QCA 236 the son borrows money from his Queensland aged father. The son refuses to pay it back.

    The son, in the first court case, successfully argues that the monies were given to him as a gift.  However, the Court of Appeal held that the amounts were loans.

    Portrait of an ungrateful childchild loan agreement

    The son’s company suffers financial stress.  The son gets $98k from this Dad. The boy continues to borrow more money from dad.

    Later, the son borrows his father’s credit card. The boy clocks up another $13k of debt.

    The First court case

    His Honour said that Dad failed to prove a legal binding agreement. There was no paperwork. There was no written loan agreement.  It was a gift.

    The Judge said:

    • The son promised to look after his Dad in old age. But that was just a moral obligation.
    • Dad is making the payments to the son, for the benefit of the company, was simply discharging his parental obligations. This is because their daughter was an employee at the son’s company.  The money was therefore of a charitable nature. Dad was protecting the son’s company so his daughter would keep her job.
    • Dad allowed his boy to use the credit card when the boy was injured and impecunious.  These circumstances are charitable.

    Good sense prevails in the Appeal

    The Court of Appeal had a better sense:

    • The lengthy period it took Dad to make a demand for the money does not count against his assertion that a breach of contract existed. The Court held post-contractual conduct is not taken into account when interpreting the terms of a contract.
    • The motive Dad had in transferring his son the money, be it “charitable” or otherwise, was not relevant.

    The Court set aside the decision of the District Court.  The Court said that the monies were paid with an understanding that they would be repaid. This was an “inescapable conclusion”. The transactions were a contract of loan. The Court gave judgement in favour of Dad of $286,000 including interest.

    This is another example of elder abuse. The decision shows the perils of not signing a loan agreement. Going to Court – twice in this instance – was expensive and exhausting for the aging father.

    What happens if your child has a partner and buys a home?

    What if your child has a partner? The loan agreement may change depending on whose name the home is purchased under. Best that your child signs the Loan Agreement and buys the home just in their name. This binds your child alone, and the partner has no say in the matter. What if the partner objects? It is important to stay firm and explain it is ‘to protect your interests, it is nothing personal’. This protects yourself and your child, if the relationship with the partner does not end up ‘happily ever after’.

    What happens if the home is purchased in both your child and their partner’s name? Then both your child and their partner sign the Loan Agreement. Our Loan Agreements allows the loan to be lodged as a caveat. Or our Loan Agreement can be registered as a second mortgage – but the bank is notified. So caveats are more common.

    Visit Parents making loans to children  to start the process or seek legal advice form your own Solicitor.

    We are in no way connected to Legal Consolidated, we do not receive referral fees or commissions of any sort from them. This is purely general advice from a trusted source and you should seek legal advice form them or your own solicitor before making any decision.

    Looking for an adviser that will keep you up to date and provide guidance and tips like in this blog? Then why now contact me at our Castle Hill or Windsor office in Northwest Sydney to arrange a one on one consultation. Just click the Schedule Now button up on the left to find the appointment options. Do it! Make 2019 the year to get organised or it will be 2029 before you know it.

    Please consider passing on this article to family or friends. Pay it forward!

    Liam Shorte B.Bus SSA™ AFP

    Financial Planner & SMSF Specialist Advisor™

    SMSF Specialist Adviser 

     Follow SMSFCoach on Twitter Liam Shorte on Linkedin NextGen Wealth on Facebook   

    Verante Financial Planning

    Tel: 02 98941844, Mobile: 0413 936 299

    PO Box 6002 BHBC, Baulkham Hills NSW 2153

    5/15 Terminus St. Castle Hill NSW 2154

    Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572

    This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

     

    Evans Dixon US Masters Residential Property Fund URF under scrutiny – Warnings were given 3 years ago


    The Australian Financial Review has released an article (behind paywall) today focusing on poor performance of Evans Dixon’s internal funds marketed heavily to many of their clients. The main focus is on the fall in value of their own stock but equally on the heavily fee laden products such as US Masters Residential Property Fund (URF).

    source AFR and Bloomberg

    Well that’s almost exactly 3 years after another finance website, EVISER,  that I was very proud to be apart of, called out the fund as “A magic pudding, just not for investors” and “one of the most expensive managed funds we’ve ever laid our eyes on”. Here is that full extensive article written by John Nunan and Richard Livingston for Eviser in MAY 2016 and bear in mind that the fund was showing positive returns at the time but hiding its true colours. All data on fees and charges were relevant as of May 2016 but may have changed in the last 3 years.

    US Masters Residential Property Fund: A magic pudding, just not for Investors

    We explain why the US Masters Residential Real Estate Fund is one of the most expensive managed funds we’ve ever laid eyes on.

    KEY INFORMATION

    Fund: US Masters Residential Property Fund

    Fund manager: URF Investment Management Pty Ltd (part of Dixon Advisory Group)

    Closing date: N/A (fund is listed on the ASX)

    Website: http://www.usmastersresidential.com.au/

    PRODUCT SUMMARY

    Product type: ASX listed managed fund

    Investment type(s): International real estate

    Performance benchmarks: None

    ASX code: URF

    Minimum investment: N/A

    Distributions: Semi-annual

    Fund size (at 31 Mar 2016) $622m (market capitalisation)

    Inception date June 2011 (listed on ASX in July 2012)

    Performance (since inception) at 31 Mar 2016 11.7% per annum (calculated by Dixons based on share price performance, including dividends and adjusted for rights issues).

    FEE SUMMARY

    Investment management fee: 1.24% pa (plus GST)

    Administration fee:  0.25% pa (plus GST)

    Responsible entity fee: 0.08% pa (plus GST)

    Custodian fee: 0.02% pa (plus GST)

    Other:  listing fees, salary and wages recharges, office admin recharges, asset disposal fees, asset acquisition fees, structuring and arranging fee, debt arranging fee and handling fee (see table in article for more information)

    Performance fee: None

    Buy/sell spread: N/A (traded on ASX)

    The Magic Pudding is a classic Australian children’s book that tells the story of a pudding that, no matter how often it’s eaten, is always available for its owners to eat next time they’re ready for a meal.

    The US Masters Residential Property Fund (ASX Code: URF) is the magic pudding of investment vehicles – a continuous buffet of fees for the manager and promoter, Dixon Advisory Group (now Evans Dixon) and its associates. When we first read the fund’s financial statements we were amazed at the number of different fees Dixon and its associates (which we’ll refer to simply as ‘Dixon’) were able to charge to the fund. However, buried deep in the balance sheet or related party notes, we’d find yet another fee.

    But it’s not just the fees that worry us about this fund. We have so many questions about the fund, its strategy, the strength of its balance sheet and the risks, that even if we were to ignore the fee load, we’d be unlikely to ever get comfortable making an investment.

    The fund and its investment strategy

    Launched in 2011, and listed on the ASX in 2012, the fund was initially presented as an opportunity for Australian investors, with the benefit of a strong Australian dollar, to invest in residential real estate in the New York metropolitan area (mainly Hudson County, New Jersey) at attractive valuations. Rental yields were expected to be greater than 8 per cent a year.

    Over time the investment strategy has morphed into what is today, a strategy of buying and renovating properties in neighbourhoods undergoing rapid growth and gentrification, with the intention of ultimately leasing them. This has transformed the fund into less of a passive, rent earning investor and more of a property speculator, with a large proportion of the fund’s earnings coming from revaluations of the properties it owns (more below).

    Property investors know that managing (and renovating) a property isn’t a simple or cheap exercise and this shines through in the portfolio owned by this fund. The fund requires a large range of services, with the key ones provided by Dixon. In addition to being the investment manager, Dixon provides the following paid services: the responsible entity; administration and accounting; architecture, design and construction; property management and leasing; property acquisition and disposal; execution, structuring and arranging (capital raisings); and debt arranging. Dixon also charges a handling fee when it raises new capital from its clients.

    You won’t be surprised to learn this shopping list of services isn’t cheap. Details of some of the services and the fees charged can be found in the Services and Fees  section of the fund’s website. In Table 1, we’ve summarised these and the others we’ve found scattered throughout the financial statements and the Product Disclosure Statement (PDS).

    We’ll return to the smorgasbord of fees in a moment. First let’s take a quick look at what the fund owns and where the money comes from.

    The portfolio

    Pictures of funky Brooklyn, Manhattan and Hoboken townhouses are scattered throughout the regular quarterly updates (click here for the 31 March 2016 update). However, it’s not what the properties look like, or where they’re located that’s of interest to us. We’re focused on whether they’re being leased or not.

    Table 2 shows the fund’s portfolio at 31 March 2016, including both freestanding properties owned directly and multi-family buildings owned through various joint venture entities. The status of these properties is as follows:

    Occupied (leased) – 63 per cent
    Renovation/turnover – 34 per cent
    For lease – 3 per cent

    Due mainly to renovation works, effectively a third of the fund’s assets aren’t available for lease. Combined with rising valuations and falling rental yields, this means the days of the fund being a high yielding investment are gone, at least for now.

    In the year ended 31 December 2012, the fund earned $4.2 million of rental income on an average investment property balance of $67 million. Given the rapidly growing nature of the fund it’s a very rough estimate, but this equates to an average rental yield of over 6 per cent. Revaluations of properties contributed another $5.7 million of profit (a little more than the rent).

    Fast forward to 31 December 2015 and the (now much larger) fund earned almost $22 million of rental income on an average investment property balance around $703 million. That equates to an average yield just over 3 per cent. Meantime, property revaluations contributed almost twice as much as rent – about $40.8 million.

    These figures highlight the increasingly speculative nature of the fund’s investment portfolio and also why the fund has struggled to generate positive operating cash flow since its inception. Even if the fund shifts to a position where the portfolio is fully (or almost fully) leased, this basic proposition is unlikely to change, at least anytime soon.

    In the 31 March 2016 update Dixon estimated that the fund would earn another USD11.4 million in rent from the properties currently being renovated. While this might eliminate last year’s $14.4 million ‘core’ loss (see Table 4 and related discussion below) it would only reduce the negative $30.6 million operating cash flow, not turn the fund into a positive operating cash flow producer.

    The fund has a low level of income, high level of expenses and relies on non-cash items to turn a profit. This, together with its growing acquisitions, means that it has had to continually tap unitholders on the shoulder for further capital and borrow from a variety of sources.

    The current funding structure for the fund is set out in Table 3. A key feature is the two tranches of URF Notes that were issued in 2014 and 2015 and pay a fixed interest rate of 7.75 per cent.

    The use of borrowing adds to the speculative nature of the fund’s portfolio. In the case of the URF Notes, often the fund is effectively borrowing money at 7.75 per cent to buy assets which won’t earn a cent initially, will have substantial sums spent renovating them and then will be put out to lease to earn rental income at a rate of say 3 to 4.5 per cent (although hopefully calculated on an upgraded book valuation).

    Put this way, it’s fairly obvious why the fund’s strategy is such a cash drainer in the early years and how it could come unstuck. A downturn in the New Jersey or Brooklyn property markets (where most of the fund’s assets are located) could place pressure on both the ability to revalue the properties upwards (post renovation) and flat or falling rents. In this scenario the ability of the fund to pay its interest bill and generate a reasonable profit for unitholders, could be pushed a long way into the distant future.

    Depending on the severity, a property downturn could cause the fund to have to sell properties in order to repay the URF Notes (which mature in 2019 and 2020) and other debts, exacerbating the fund’s problems in generating cash.

    The early year cash flow drought associated with the underlying portfolio is magnified by the substantial levels of fees and other expenses incurred by the fund.

    Let’s take a look at them in more detail.

    Financial analysis

    To put it bluntly, we’ve seen very few fee-fests like this fund. Perhaps some of the crazy tax deals beat it – for instance, managed agricultural schemes – but we struggle to recall a more traditional investment fund that’s paying fees in the order of five per cent or more (calculated as a percentage of the net asset base), year-in, year-out.

    Admittedly, it’s not an apples for apples comparison to something like an Australian share fund, since property is typically a more expensive asset class to manage. But asset class alone doesn’t explain the continually high fee load being borne by this fund.

    Table 4 shows the fund’s accounting results for each year since it was launched, and Table 5 shows some key financial ratios. We’ve used our own display format as it better demonstrates how the fund loses money on a ‘core’ basis each year, but generates a profit through renovating and revaluing the properties and, perhaps even more importantly, foreign exchange (FX) gains. It also highlights the amount of fees that have been paid by the fund since it was created.

    At 31 December 2015, the fees totalled almost $100 million, and there’s a chance we’ve missed some as the fund’s disclosure of fees is both complicated and in a constant state of flux. If there’s an easily digestible summary of the fees paid by the fund somewhere on the Dixon website, we haven’t found it.

    We’ve already discussed the fund’s low level of income and high levels of URF Note interest. When you add in the fees, it explains the large operating cash outflows the fund has experienced since launch. Cumulatively, the fund has burned through almost $50 million in operating cash flow between launch and 31 December 2015.

    Fees on borrowed money

    Dixon is paid an extraordinary array and volume of fees, but that’s not the only issue. Despite earning fees for managing and renovating the portfolio, making
    purchases and sales and raising money, Dixon is paid an investment management fee of 1.24 per cent (for whatever aspect of the fund’s investment management that hasn’t been paid for already), together with administration (0.25 per cent), responsible entity (0.08 per cent) and custodian fees (0.02 per cent). Added together, these percentage fees add to 1.59 per cent, plus GST.

    Scarily, these fees are paid on the gross assets of the fund, so it currently works out at around 3 per cent based on the unitholders equity (with all the transaction based fees on top). This is a massive fee load but even worse, the fact the fees are on gross assets gives Dixon a strong disincentive to deleverage the fund (at least, by diverting income or asset sale proceeds to paying down debt) since they’d effectively be costing themselves a substantial amount of money. A perverse incentive like this is the very reason we don’t like geared investment vehicles paying fees on gross assets.

    So there you have it: the fund is an extraordinarily expensive cash burner. However, the fund has survived and prospered, largely on the back of three critical factors: property revaluations, foreign exchange gains and the ability to regularly source new capital and borrowings.

    Performance

    Table 4 demonstrates how the fund relies on property revaluations and foreign exchange gains to compensate for large ‘core’ losses. While the gains on  revaluations may ultimately be reflected in a higher level of rental income (or asset sale proceeds) the FX gains are ‘one-off’ profit items that may not be  repeated, or may even reverse themselves in future years.

    Worryingly, through to 31 December 2015, FX gains on translation contributed almost 100 per cent of the cumulative post-tax accounting profits of the fund.
    Effectively, for all of the fund’s activity and the substantial revaluation gains made as a result of renovations, the fund’s accounting profits to date have more to do with the recent depreciation of the AUD against the USD than anything property related.

    In the 31 March 2016 update, Dixon reported that the fund has produced returns of 11.7 per cent a year since its launch in June 2011. However, over that same period, the US dollar itself has returned over 7 per cent a year (measured in AUD returns) and a simple US property , such as the Vanguard REIT (NYSE Code:  VNQ), has returned around 11.5 per cent.

    In AUD terms, that works out at almost 20 per cent a year for a simple real estate , that doesn’t have the development risk or financing risk associated with URF. URF is a great example of reasonable absolute performance hiding terrible relative performance.

    Risk

    More worrying than the lacklustre performance is the amount of risk taken to achieve it. At first glance, a debt-to-equity ratio for a property trust of just under 50 per cent (at 31 March 2016) is nothing to get too worried about. But this fund is no ordinary property trust. It’s part property owner, part developer, part FX speculator (due to the fact it has issued the URF Notes in Australian dollars) and part guarantor of the juicy Dixon fee arrangements.

    Without knowing whether Dixon intends to ease off the ‘buy and renovate’ strategy, repay the URF notes, or restructure some of the fee arrangements it’s difficult to tell when this fund may produce positive operating cash flow, or indeed whether it will ever do so. That means it’s relying on being able to raise further capital, borrow, or sell assets at a profit in order to pay the bills.

    The problem with this type of approach is that everything can come unstuck at once. A downturn in the property market would make it difficult to sell assets
    at a profit and tough to borrow or raise capital (except at a large valuation discount). In that scenario, the fund may be forced to sell assets at discounted
    valuations to raise cash and if that happens the debt to equity ratio can increase rapidly.

    If the fund had a property portfolio generating, say, a 5 per cent rental yield, with expenses running at 2 per cent a year, the story might be very different. In that case, it might be able to sit tight, pay its interest bills and wait for a recovery. However, the fund’s constant operating cash outflows means it has to continually tap unitholders and lenders for more cash and if that dries up, the conservative approach is to assume it will have big problems.

    Summing it up

    We could dig further into the property portfolio – for instance, analyse per square metre lease rates for Hoboken rental properties – but it really doesn’t matter. This fund has produced relatively little for investors versus alternative investments, largely because it suffers under a crushing fee and expense load that has eroded a lot of the gains produced by FX movements and a buoyant underlying property market.

    Looking forward, with FX gains more difficult to come by, unitholders are taking on an enormous amount of risk since the fund is now substantially leveraged and has an expense load that keeps on increasing. It’s unclear exactly how a property downturn might play out, but our concern is that this fund could end up suffering a crunch and suffer massive losses from having to sell assets on the cheap.

    If you know enough about New Jersey property to be bullish on freestanding Hoboken houses, buy one directly, or team up with some fellow investors to do so. But if you’re simply an Australian SMSF trustee looking for some exposure to global property and infrastructure, there are plenty of better options available. You simply don’t need this fund, or the expense and the risk that comes with it.

    Disclaimer: This article is general in nature and does not take your personal situation into consideration. This article is not a recommendation of any investment or facility mentioned in it, and you should seek financial or legal advice specific to your situation before making any financial and/or investment decision. This  disclaimer is in addition to our standard Terms and Conditions. The Product Disclosure Statement (Offer Document) for this fund can be found here.

    Are you looking for an advisor that will keep you up to date and provide guidance and tips like in this blog? Then why not contact me at our Castle Hill or Windsor office in Northwest Sydney to arrange a one on one consultation. Just click the Schedule Now button up on the left to find the appointment options.

    Liam Shorte B.Bus SSA™ AFP

    Financial Planner & SMSF Specialist Advisor™

    SMSF Specialist Adviser 

     Follow SMSFCoach on Twitter Liam Shorte on Linkedin NextGen Wealth on Facebook   

    Verante Financial Planning

    Tel: 02 98941844, Mobile: 0413 936 299

    PO Box 6002 BHBC, Baulkham Hills NSW 2153

    5/15 Terminus St. Castle Hill NSW 2154

    Corporate Authorised Representative of Viridian Select Pty Ltd ABN 41 621 447 345, AFSL 51572

    This information has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation and needs. This website provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

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