Understanding the commercial property market
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Understanding the commercial property market

Understanding the commercial property market

By Hamish Wehl

Australians’ love affair with, and focus on, residential property means that a whopping 68 per cent 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 tenant’s 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 per cent in 2016, compared to commercial property yields of 6.3 per cent 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 fully understand what they are investing in if they are to succeed.

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.

  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, 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 fact that location is often outside of major centres
- Specialist industrial properties can be difficult to re-lease if tenant leaves

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

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 however, 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

The characteristics of A-REITs are examined briefly 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 per cent 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.
- They 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 five to seven 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 per cent 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 it 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 per cent over the last five years, 8.9 per cent over the last 10 years, and 10.5 per cent 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).

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.



About the Blogger

Hamish Wehl

Hamish Wehl

Hamish is responsible for overseeing Cromwell’s unlisted retail funds management business including retail investor relations, products and strategy. Hamish has 14 years of experience as a property and financial services professional in both Australia and the United Kingdom.

He is a chartered accountant, holds bachelor degrees in business management and commerce, and a masters of philosophy in real estate finance from Cambridge University.

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Understanding the commercial property market
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