Hailed as the biggest potential asset class in Australia, the $3.1 trillion locked up in residential property has always been in the sights of institutional investors, but barely features in their portfolios. A new home loan product may change all that as CATHERINE JAMES reports.

Loosely termed an “equity finance mortgage” (EFM), the product’s name is somewhat misleading since although the EFM is, legally speaking, a mortgage, it does not carry any interest rate and has returns that replicate valuations of the equity in the underlying residential home.

On the other hand, the EFM is not equity either – that is, investors have no ownership stake in the borrower’s property, just a mortgage secured over it. This is one of the appealing aspects of the product since it means that investors do not suffer from the traditional transaction cost leakages (eg, stamp duty, land tax, and maintenance costs) that usually hit direct property investments.

The return for the investor is made upon sale of the property. The investor receives a higher percentage of the capital growth on the property than the percentage they initially loaned. For example one EFM provider, Sydney-based Rismark, provides finance for 20 per cent of the value of the borrower’s home on a zero-interest basis in exchange for 40 per cent of the future capital growth. If the value of the borrower’s home falls, and they sell their home for a loss, Rismark will also potentially wear up to 20 per cent of the losses.

Despite residential property being one of the most developed investment markets globally, mortgages appear to have become a dirty word as, in the words of one investor, “it’s the market that’s biting the world at the moment”. A handful of superannuation fund executives approached for comment on investing in residential property said they wouldn’t touch it. But then, nor had they heard much about EFMs.

However, some institutional investors must be interested in EFMs, or else Mercer Investment Consulting wouldn’t have one of its principals dedicate months of research to the emerging asset class. Still in the throes of this research, Melbourne-based David Lee is reluctant to pre-empt his findings with statements on what he has found so far, but he admits “it’s proven to be one of the most complicated things I’ve ever looked at”. “On the one hand this is a very simple financial concept. There is not much new in adding an extra layer in the ‘stack’ of securities that are used to finance any particular asset. But on the other hand the execution and implementation of this concept for residential real estate has proven to be complicated and challenging,” he says.

Apart from their complexity in comparison to direct property investment, EFM vendors are also struggling for scalability in the Australian market It is understood only one provider, Rismark, has made it to market with institutional backing to date. Rismark opened in March 2007 in partnership with Adelaide Bank. Managing director Christopher Joye says it took three years to get Rismark off the ground, and he suspects his would-be competitors are having as much of a struggle getting funding as he did at the start.

Rismark has one fund called the Rismark Active Property Trust. It is an open-ended fund with no capacity constraints – Joye says it could easily take several billions. He says the trust holds investments in hundreds of homes, with over $150 million worth of residential properties in its portfolio. While a minimum investment is $1 million, Joye said investors are expected to make “commitments” of between $50 million and $100 million. Rismark has eight patents on its products, protecting various items of its intellectual property and any possible derivations of it.

A plug for the product by the Australian Labour Party in its ongoing campaign to address the country’s housing affordability crisis has helped Rismark’s cause, as have rising interest rates. “Every time interest rates increase, it makes our product more attractive. The relative cost of an EFM decreases as the interest rate increases,” he says. Rismark has a number of criteria around building an investment portfolio of these loans based on years of research of the housing market and borrowers.

Such criteria includes not lending to anyone over 65 years old (given reputational concerns around exploiting the retiree market), and putting a limit on how many first home buyers are funded. Rismark also ensures at least 60 per cent of the gains on the property remain with the borrower, to encourage the borrower to maintain their home.

The target return for Rismark in the long term (25 years) on an ungeared basis is around 16 per cent. The shortterm target return for a two to three year ungeared investment is pitched around 20 per cent plus. Joye says that Rismark hopes to deliver these return targets with volatility that is less than that of 10-year government bonds. Joye is confident of the long-term return prospects for Rismark’s funds as it is underpinned by the “exceptional historical performance” of the Australian residential market, which has outperformed almost all of its international peers over the last 30-40 years.

The other attraction to investing in residential property is the low correlation to equities and other assets. Mercer’s Lee says his data shows that a well-diversified portfolio across every capital city in Australia would provide a “reasonable” level of volatility and correlation to other asset classes.

Residential property beta is based on Australia’s house price index, which in the long term has averaged around a 6 to 7 percent increase each year. Lee thinks a good manager could get a low double-digit return from “capturing the upside” of house price appreciation through the terms of their EFM contracts. Alpha would be achieved through superior selection of customers, Lee says.

In Defence of direct res property

Direct investment in residential property is available to institutions through a handful of funds, such as the Westpac Residential Property Trust, an unlisted pool of currently 441 houses throughout Australia. The houses are residential properties let to Defence Housing on a longterm lease. Lance Vassarotti, who designed the fund, says the trust offers the scale and diversity needed to get adequate exposure to this asset class.

Partnering with Defence Housing helps manage the administrative aspects of the portfolio. “One of the impediments to this market is you need scale and you need diversity, but with scale and diversity comes problems managing the portfolio, so Defence are great partners with us because they manage this otherwise difficult portfolio scattered all around the country,” Vassorotti says.

Defence Housing looks after the tenancy issues at a local level. It is also the official tenant, so there is no vacancy risk for the period of the lease. Buying units in the trust gives the investor exposure to both the rental income and the capital growth of the underlying assets. Defence Housing is still Westpac’s lone partner since the property trust opened in June 2006, but Vassarotti says the plan is to expand with more partners. “Defence is only one platform of the trust. We’re in discussions with a number of other parties for other residential property assets, so over time Defence will only be one part of a much larger residential property trust,” he says.

The trust is currently being valued, however the last valuation in June 2007 tipped it to have around $226 million of assets.