The “small cap”, or should that be, the “small town” premium in the Australian property market

July 31, 2014 / By  

Does Adelaide offer property investors a free lunch?

As the JLL Analyst for Adelaide, my colleagues never pass up the opportunity for a light hearted jab at our “small town” ways. Adelaide’s largest ever residential tower development was recently described by a Sydney colleague as a three storey walk up.

But, jokes aside, this got me thinking. In equities markets, it can be a good thing to be small. So maybe the same argument can be applied to property?

The “Small Cap Premium” theory describes the tendency for stocks with smaller market capitalisations to outperform the wider market. Without going into detail, here are some reasons for the phenomenon.

  • The low information nature of small cap stocks means that for fund managers, researching and pricing these stocks is not cost effective, and hence they are avoided.
  • Low information markets are less efficient, with a greater prevalence of mispricing, and for those with the necessary time and expertise, bargains can be found.
  • Smaller stocks tend to be more nimble, able to react to market shifts (or shocks) swiftly and take advantage of changes, or minimise losses.

So, can we apply the same reasoning to smaller commercial property markets? Well let’s run through those same explanations again.

  • The big AREITs are generally underweight (or absent) in the Adelaide market. Assets of sufficient value to warrant their attention are scarce, and many feel less comfortable in a market with which they are unfamiliar.
  • Adelaide could also be described as a low information market. Australia is third most transparent real estate market in the world, but with fewer firms committing resources to researching Adelaide, it could be argued that the pool of research knowledge is far shallower.
  • Adelaide has a greater proportion of private ownership, and a number of these local private investors have been very successful. Their ability to make quick decisions, without the constraints of a corporate decision making structure, is probably a big part of this success.

Returns in Adelaide are historically greater than those of the eastern states, as they well should be, to reflect the risk premium of our market. But even when comparing apples with apples, Adelaide has outperformed.

An analysis of the JLL Total Returns Index demonstrates that despite greater returns, the volatility of Adelaide is only marginally higher than that of Sydney or Melbourne. Furthermore, Adelaide’s Sharpe Ratio (a measure of risk adjusted returns) over the last 10 years is significantly greater.
So is this a free lunch? Let’s not get carried away. Firstly, this 10 year period of returns includes the Global Financial Crisis and the associated increase in volatility, and secondly, there is a great deal of risk not captured in the volatility of a decade’s returns. These results need to be considered in context, but they are interesting none the less.

All I can tell you is, with the best food and wine in the country, free or not, lunch in Adelaide is a beautiful thing.

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