Understanding the commercial property market

Australians’ love affair with, and focus on, residential property means that a whopping 68% of the average household’s total wealth is allocated to this one asset type¹. Most investors will understand this lack of diversification increases risk and introduces volatility.

The defensive characteristics of property, however, are still very much in demand from yield-hungry investors and one option available to them is to consider commercial property as an alternative to their residential investments.

Property in your portfolio – beyond residential

Security of income from commercial property is generally higher than residential property due to the binding nature and longer term of commercial leases. Additionally, commercial tenants’ financial covenants are often superior. Commercial tenants are also often responsible for the majority of outgoing expenses whereas residential tenants are not, providing investors in commercial property with a higher percentage of rent received.

According to CoreLogic², average rental yields for houses in Australian capital cities fell to a record low of just 3.1% in 2016, compared to commercial property yields of 6.3% for the year to 31 December 2016³. Both types of property offer the potential for capital growth.

Like all investments, there are risks and traps associated with commercial property, and investors need to understand the characteristics of the asset class before committing.

Commercial property sub-sectors defined

Commercial property refers to all non-residential real estate and is divided into three main sub-classes – office, retail and industrial.

Large number of diverse sub-sectors
Wide range of grades of property, from premium quality office towers to basic suburban office blocks
Options include entire properties as well as strata floor plates and individual offices within buildings
Location varies from CBD, outer CBD, regional and suburban, also impacting on grade
Large number of diverse sub-sectors
- Options for investment include large metro centres, regional centres, specialist retail hubs and individual assets
- Locations vary from CBD to metro to regionals and suburban
Large number of diverse sub-sectors
- Options for investment include large metro centres, regional centres, specialist retail hubs and individual assets
- Locations vary from CBD to metro to regionals and suburban
Large number of diverse sub-sectors
- Options for investment include large metro centres, regional centres, specialist retail hubs and individual assets
- Locations vary from CBD to metro to regionals and suburban

Table 1: Features and General Return Profile of sub classes

	Office	Retail	Industrial
Features	Large number of diverse sub-sectors Wide range of grades of property, from premium quality office towers to basic suburban office blocks Options include entire properties as well as strata floor plates and individual offices within buildings Location varies from CBD, outer CBD, regional and suburban, also impacting on grade	Large number of diverse sub-sectors Options for investment include large metro centres, regional centres, specialist retail hubs and individual assets Locations vary from CBD to metro to regionals and suburban	Sites are frequently custom-built/designed for specific tenants Individual industrial properties vary considerably from one to the next Lower barriers to entry than retail or office due to fact that properties are typically cheaper and quicker to construct
General return profile	Yields sit between retail and industrial Yields differ substantially depending on the grade of the property (premium property is generally lower yield than lower grade properties for example)	Provides the lowest yield of the three core commercial sectors Often requires greater capital expenditure (capex) than other sectors In challenging economic times, non-essential retail can struggle	Provides the highest yield Lower capital growth potential due to the fact that location is often outside of major centres Specialist industrial properties can be difficult to re-lease if tenant leaves

Options for accessing commercial property

In general terms, investors have two options – they can buy a property directly themselves, or pool their money with others.

Direct investment can definitely pay big dividends – many a family fortune has been founded on the back of astute accumulation of commercial property, but for the majority of individual investors, buying and managing a commercial property is neither possible nor sensible. The high cost of most commercial property makes it financially out of reach, and maximising returns from a commercial property requires serious skill and expertise, which individual investors may not have.

Direct commercial property investment within an investor’s SMSF is becoming more common, in particular where members own commercial premises and look to transfer them into their fund. There are, however, barriers to this in the form of SMSF borrowing and contribution caps legislation, and it could also be considered questionable in terms of diversification where a person’s income and superannuation fund both rely on the one place of business.

1. Listed property (A-REITs) investment – property, in a liquid form
A-REITs were discussed in detail in our last issue, and the characteristics are examined briefly again as follows:

Benefits

Considerations

Liquidity Professional management of the property portfolio
Small investment gives access to a large, diversified portfolio
Smooth income (yield) underpinned by commercial leases as well as the potential for capital gain when properties are sold
Reliable income levels – A-REITs must distribute at least 90% of their income to investors in the form of distributions
Income may be tax-advantaged due to the favourable tax treatment of property depreciation by the ATO
Transparency

Gearing levels (watch they are not too high)
A-REITs are subject to general market sentiment and movements (unrelated to the underlying property portfolio) and are closely correlated with equity markets
Do not provide as direct an exposure to property as an unlisted trust does
Do not provide significant diversification benefits to equities

2. Unlisted property – trading liquidity for a more direct property exposure
Unlisted property trusts are also known as property funds, syndicates, or schemes. They allow investors to buy units in a professionally managed trust which directly holds investment property or properties. Unlisted property trusts can be closed-end (fixed duration of usually 5-7 years) or open-end (no set duration with limited liquidity throughout).

Benefits

Considerations

Potential for direct access to a high quality portfolio
Smooth, stable reliable income stream as 100% of rent (net of expenses) from the property portfolio is distributed to investors in the form of income
Income can be tax-advantaged due to the ATO’s favourable treatment of depreciation of property assets
Returns are closely linked to the underlying property assets and are less affected by general market movements than returns from A-REITs
Value is based solely on the valuation of the underlying assets, which generally occurs annually
Unlisted trusts are not highly correlated to other asset classes
Good hedge against inflation as lease payment increases are usually inflation-linked or have fixed increases

Initial investment in an unlisted trust is usually much larger than for an A-REIT, typically with minimums of $10,000 or more
Closed-end unlisted trusts are illiquid during the term of the trust and can be difficult, if not impossible, to exit the trust
Open-end unlisted trusts may offer some liquidity but investors need to understand the mechanics of the term or duration of the trust

The bottom line: commercial property is a valid alternative when investors have so much of their wealth tied up in the residential sector.

Commercial property investment has historically delivered attractive risk adjusted returns with an average (annualised) total return (inclusive of income and growth) of 11.0% over the last five years, 8.9% over the last ten years, and 10.5% over 15 years, up to December 2016, according to the MSCI All Property Universe Index (which is published by MSCI’s analysis of over 1,440 Australian commercial properties)³.

Whether purchasing commercial property directly or by pooling your funds with others and investing into REITs or unlisted property trusts, the benefits of investing into commercial property certainly should be considered within a diversified portfolio.

Footnotes:

1. Australian Bureau of Statistics (ABS), Australian National Accounts: Finance and Wealth, September 2016, Release 5232.0
2. CoreLogic Hedonic Home Value Index, December 2016
3. MSCI IPD All Australian Property Index December 2016

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