Commercial yield risks explained

By

07/06/2018

Australians have a love affair with property. Many see property as a key tool in achieving their financial goals, and it's easy to see why, given its historically low volatility and potential to provide both income and capital returns.

To date, residential property has bene by far the most popular way for Australians to enter into and retain exposure to the property market. I have more than 15 years of experience as a property and financial services professional in both Australia and the United Kingdom, and during this time, I have come to understand that owning a home is seen as the 'great Australian dream'. It is a well understood and familiar process for most people, and many Australians own more than one investment property.

The enormous investment in houses, apartments, unit blocks and holiday homes has led to many investors being ‘overweight’ in the residential sector, however.

Many people also choose to buy investment properties in the same town or state as their home, further increasing their risk of capital loss if residential property prices fall.

The cost of residential investing

While an investment in residential property has generally achieved strong returns, the ongoing cost of owning a residential investment property, both financially and time-wise, is often underestimated. Council rates, insurance, land tax, ongoing maintenance and capital works add up rapidly and can eat into capital gains.

In addition, residential property investments generally provide a low income yield – often lower than the costs of borrowing associated with the property – which makes them negatively geared.

Only a small portion of investors have exposure to commercial property, yet it is an asset class that yield-hungry investors cannot afford to overlook

Negative gearing generates a tax loss that can be offset against other income; however, any loss needs to be recovered before a profit is made. Generally, investors are reliant on strong capital growth to make a profit on their residential investment – a bet which isn’t guaranteed to pay off. So what are the alternatives?

If the term ‘commercial property’ conjures up images of dusty old warehouses, think again. Commercial property is a broad term that covers all kinds of property, from offices and retail outlets to industrial sites, doctors’ surgeries and even car parks. 

In Australia, only a small portion of investors have exposure to commercial property, yet it is an asset class that yield-hungry investors cannot afford to overlook.

As of September 2017, commercial property achieved an average total return of 11.1% per annum over five years and 11.6% over one year – a sound return in a low-yield environment, and one that outpaced most residential markets (see the chart on p 41).

Unlike residential, commercial property investment is often centred on the basis of yield or income. Yield is the rent-to-value rate for a property, which is often higher for commercial properties than residential.

Now that I’ve outlined the benefits of commercial property, I’ll discuss the various types of commercial investments and their yield risk and benefits.

Retail property

Retail is a broad sector that covers small suburban shopping centres through to large malls. Generally, retail has the lowest yield, while ongoing capital expenditure can be significant to retain the premises at a high quality to attract customers. Retailers also tend to be impacted by economic factors, shopping trends, location and tenant mix issues, all of which can have impacts on patronage and therefore on rental income.

Office property

The yield from office property varies widely, from a low yield on a premium-grade building through to a high yield on a C- or D-grade building. A premiumgrade building tends to attract more financially secure tenants, hence the lower risk profile and return for investors. It’s important to understand the supply and demand characteristics of the area, location, length of leases, and the tenants and their changing needs. As an example, government and blue-chip tenants have increased demand for newer, environmentally sustainable office buildings in recent years.

Industrial property

Industrial property is usually quick and relatively cheap to construct, and is located outside major capital cities with limited capital growth potential. For these reasons, industrial property generally provides the highest income yield. The risk of obsolescence when a tenant vacates a purpose-built facility means it’s especially important that detailed due diligence is undertaken.

 

 

 

 

 

 

 

 

 

Specialty property

Specialist property includes hospitals, storage centres, pubs, hotels, retirement villages and childcare centres. These types of assets tend to require intensive management by a specialist operational manager. Investors need to have confidence in the management and the business model. As these properties are purpose-built, there is significant risk if the existing tenant vacates the premises.

How can you invest in commercial assets?

Purchasing a property asset directly is a method commonly used for residential property investments. However, with commercial property, this is usually an unfeasible approach for the everyday investor for a number of reasons. It can be highly expensive, requires a larger deposit than residential, can limit diversification within your portfolio and can lead to an extremely high risk profile for an individual investor.

"Yield is the rent-to-value rate for a property,
which is often higher for commercial properties than residential"

A more accessible and cost-friendly approach for investors to access commercial property is through private syndicates, ASX-listed real estate investment trusts (A-REITs) or unlisted property funds. 

Private syndicates exist when a group of investors club together, either privately or with the help of a manager, to pool their money and buy property. This type of investment generally requires a high level of investment by each investor. Often there is no way to exit the investment without finding another buyer, and unless there are significant sums to invest, portfolio diversification can be limited.

A-REITs are for investors looking to spread risk across a wide range of property sectors, types and geographical locations. As professionally managed portfolios of listed properties, which can change over time as the manager looks to improve the portfolio, A-REITs can be traded openly on the ASX. The value of A-REITs moves with broader equity market sentiment, which can cause the value of the investment to be more volatile than a direct investment in property.

Unlisted property funds are professionally managed unlisted property funds, which provide an alternative way to invest in commercial property. As their prices are based on the underlying valuation of their property assets and not directly influenced by the equity market, their price volatility is lower than that of A-REITs. They can also provide additional portfolio diversification benefits, as the returns are not highly correlated to A-REITs.

There are two key types of unlisted property funds. Open ended property funds do not have a finite maturity date and can continue to issue units so long as they raise money to purchase additional properties. These funds usually hold some cash to provide liquidity to exiting investors. 

The other type of unlisted property fund is fixed-term or closed-ended. Assets are generally held for five to 10 years, at the end of which investors in the syndicate can vote on the future of the trust. The default outcome is usually that the asset is sold, the trust is wound up and investors are paid out. These are generally illiquid investments, and investors must commit their funds for the full investment term.


Considerations before investing in unlisted property funds

Share market volatility has increased investor interest in high-yielding unlisted commercial property. The current cooling of the residential property market is also leading many investors to look elsewhere for portfolio returns. 

Unlisted property funds have proven popular, as they are fairly easy to understand and provide a high level of transparency over which properties will be owned. Before making an investment, there are many factors investors should consider when deciding if an unlisted property fund is the right option.

Financial advisors can assist in this decision-making process, as they have access to independent research reports that compare property trusts by organisations that have no link to the fund manager, such as Lonsec, Zenith or Standard & Poor’s. In addition, managers provide plenty of detail in their fund Product Disclosure Statement (PDS) documents.

"Unlisted property funds have proven popular,
as they are fairly easy to understand and provide a high level of transparency"

When looking into a manager’s reputation, consider their experience, past performance, in-house investment expertise, and transparency around portfolio holdings and investment returns. Also take a look at the assets the fund invests in. The term ‘location, location, location’ applies as much to commercial property as it does residential. For example, are office or industrial assets in the ‘right’ part of town? Are they well connected to transport links? What level of vacancy exists in this area, and are there other buildings becoming available?

There are other things to consider, too, such as the quality of the building and its tenants, the rent being charged, and the lease term.

It’s also important to consider the green credentials of the property, which are becoming increasingly important to tenants such as large corporates and government. Commercial buildings are now rated under the NABERS (an ongoing energy use rating) and Green Star (a green design rating) schemes. If your property doesn’t make the grade, you could be limited in the tenants you can lease it to.

Yield and risk

One final point to keep in mind when considering commercial property investments is the direct relationship between yield and risk. Investors must decide how much risk they are willing to take on and choose the asset class and fund that matches their risk profile. The more yield a fund generates may indicate a higher risk exposure.

Another important risk factor that investors should consider is liquidity risk. Closed-ended unlisted property funds are considered illiquid assets, so if you expect you may need access to your investment before the fund term, an open-ended fund (with liquidity) may be more appropriate.

Investing in commercial property can be a great way to diversify an investment portfolio that could already include residential property, shares and bonds. As an alternative to adding another piece of residential real estate to your asset base, you may want to consider the benefits of a commercial investment.

You don’t need to have the skills and experience to invest directly in order to enter this market. Selecting an unlisted property fund run by a skilled and trusted manager, who can diligently acquire the right property, add value through quality management, and handle the day-to-day operations, can make commercial property a relatively simple asset class to invest in. Investing in this manner also means you don’t need a huge amount of capital to get started investing in the commercial property market.

The key to success is to make an informed choice and to find the right manager and portfolio to deliver the regular income and capital returns that are intrinsic to this asset class.


Hamish Wehl is head of retail funds management at Cromwell Property Group,
where he is responsible for overseeing the unlisted retail funds management business.

 

 

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