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Jason Huljich
Commercial Property Expert
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Can property investments provide a yield to live on anymore?

Friday, August 04, 2017

By Jason Huljich

Real estate investment has performed very well across the board for investors over the past few years. But depending on what investors are looking for, not all property investment is the same. If you’re looking for a yield to live on, commercial property may just be the answer. 

For many investors, and particularly those in or heading towards retirement, yield can be everything. Capital growth is important, but it’s the yield that makes the difference between living on the returns from your investments and drawing down on capital too soon. But with interest rates at record lows, returns from low-risk assets like cash and fixed interest are pretty grim, and investors are facing up to the reality that they need to look at other asset classes to achieve the returns they need.

Residential property can provide stellar total returns – but for how long?

According to a 2016 Long-term Investing Report produced by the ASX and Russell Investments, Australian residential property has been the top performing asset class over the past 20 years. Yet at the same time, in our low-growth, low-return world, Australia’s commercial property sector – including office towers, industrial facilities and shopping malls – has also delivered standout returns.

In fact, data produced by the Property Council of Australia shows that as at March last year, the average annual return on commercial property was 14%, excluding leverage. Add in leverage, and the returns look even better. These are figures which compare very favourably to the 9.2% from listed property and the depressing 1.6% from fixed interest.

Unlike residential property, in commercial property, rental returns drive the results. Average income yields on the $160 billion of commercial property in the Property Council’s index was 6.6%, whereas in residential property, the picture is very different. Residential rental yields in Sydney and Melbourne are at all-time lows: just 2.8% in Sydney and 2.7% in Melbourne as at January this year.

The seemingly endless upward trajectory of residential property prices (in other words, capital growth), has been the major factor driving its great performance. But continuing to bank on massive capital gains to make up for very low yields is starting to look like a risky strategy. Tax-driven investment strategies, like negative gearing, have played a role in propping up the market, but plenty of analysts are now predicting that the tide is about to turn, or at the very least stall.

So where investors should be looking for their property exposure?

Commercial property can offer a better yield/capital growth ratio.

Investors looking for a yield they can live on, without foregoing the prospect of capital growth, could do a lot worse than commercial property. Most investors are not in a position to purchase a commercial building outright – but there are other, pooled investment options which might appeal. Unlisted property trusts are one.

Unlisted property trusts pool investors’ funds to purchase one or more properties. Investors buy units in the trust, which is managed by a professional property manager, with investors’ money remaining in the trust for a specified time period. At Centuria, the period is usually five years, with an option for a further two years if unit holders agree. Investors receive monthly income distributions (yield) from rent throughout the life of the trust, and any capital gain achieved on the sale of the property is distributed when the trust is wound up.

The good news is that the yield/capital growth profile of commercial property can be very attractive – but it does depend on a number of factors.  Chief among them is quality of the property itself, but the quality and track record of the manager is equally crucial.

Factors which impact returns from a property asset

The quality of the property and whether it is fit for purpose, i.e. will the property perform well in its market/compared with comparable products?

- Location, Location, Location.

Weighted average lease expiry (WALE). This is a measure of the amount of time that leases are locked in across the property. Depending on the property and the manager’s intention, a long or short WALE can be equally attractive. Where a property does not need a great deal of refurbishment and is tenanted by quality businesses or government departments, then a long WALE is preferable. However, some properties offer scope to be upgraded and refurbished and rents raised as a result. In this case, a shorter WALE may be better, because it means that when existing tenants leave new tenants can be brought in at higher rents.

Tenant profile. In most cases, quality corporations and businesses with a track record are more attractive than start-up companies, for example, because investors have more comfort that rents will be paid.

Factors to consider when assessing an unlisted property trust manager

The manager’s track record. A track record of success is a positive sign, and while not a guarantee, it's a good indication that future success is likely. Experience in property markets and in managing unlisted trusts is important.

Whether or not the manager is an active property manager. At Centuria, we are active managers. This means we actively seek to add value to the property assets and back ourselves to generate attractive total returns as a result. We do not use external property managers, but rather an in-house team which is close to our tenants, and knows our properties inside out. We see this as our competitive advantage – our ability to buy well and then really work our assets to get the best out of them.

-The trust structure itself. Look carefully at how the trust is structured. Is it clear when the trust can, or will be, wound up? Is it clear when distributions will be made? What is the gearing level of the trust? How well, and how often, does the manager communicate with investors?

Unlisted property trusts – some examples

We have a long track record in unlisted property trusts. To date, we have completed 33 unlisted funds – with an average return to investors of 13.2% per annum.

At the same time, not all our unlisted property trusts are the same, and our strategy with respect to different properties is reflected in different structures and outlooks for the trusts themselves. 

Sandgate Road – a bond-like structure, with better yields than bonds

Sandgate Road Fund is a ‘passive’ unlisted trust and, in this regard, is somewhat bond-like in its structure. The property does not require refurbishment as it is only four years old, offers a long WALE (9.4 years), is 100% occupied, with 81% of the space leased to State Government-owned entities.

This means that income distributions are locked and fixed, in the same way that bond yields are.

The term of the trust is six years and forecast distributions are 6.5% initially, increasing to 7% in the 2019 financial year – with additional rental growth forecast to increase distributions to 8% by the 2023 financial year.

Zenith Fund – active management in a strengthening market

The Zenith Fund – which co-owns the Zenith, an institutional grade office tower in Chatswood on Sydney’s lower north shore is arguably higher risk, but we believe has more potential upside than Sandgate.

The property required refurbishment when it was purchased, and we are about to undertake $27.8 million of capital expenditure to improve amenities. Zenith was 94.8% occupied at purchase, but with a WALE of only 2.7 years.

Given our view that metro market of Chatswood is set to benefit from falling vacancies and strong rental growth, partly due to State Government investment in infrastructure in the area, the lower WALE was very attractive.

We have already been able to raise rents for incoming tenants, and anticipate further rental growth going forward. The current yield is 7.6% and we anticipate that this will rise over the next year.

The bottom line

The nature of property investment means that it has always been appealing to investors looking for on-going yield, but with some potential upside in terms of capital growth at the end. The issue in the current economic environment is that yields from some property investments are simply not high enough, particularly for investors relying on it to live. In this case, commercial property in general, and unlisted property trusts in particular, are certainly worth considering.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Mixed outlook for Australian office property

Thursday, April 06, 2017

By Jason Huljich

Australian office property will continue to be a mixed bag in 2017. Despite the weight of offshore money flowing into Sydney and Melbourne in search of a safe-haven from global volatility, a measure of overall weakness in the Australian economy and the on-going effect of the demise of the mining boom are contributing to some very different fundamentals.

Nonetheless, according to Jason Huljich, CEO of Unlisted Property for Centuria, it’s not all doom and gloom – there remains opportunities for attractive yields and solid returns from office property for the well-researched investor.

According to the Property Council of Australia’s (PCA) most recent office property report, the Australian CBD office vacancy rate remained steady over the six months to January 2017, declining only slightly, from 11% to 10.9%. However, this steadiness belies significant differences in the markets which make up the index.

While Sydney and Melbourne remain robust, the residual effects of the end of the mining boom continue to negatively affect exposed markets. Perth has been particularly exposed to the fallout of the mining boom, and Brisbane is also feeling its impact. In South Australia, the overall economy remains weak with flow-on effects to the Adelaide CBD office market.

So, what does 2017 hold for the major office markets? The bottom line is that we are seeing little change from 2016.

Sydney and Melbourne the pick

Sydney and Melbourne are the pick of the major markets. According to the PCA, at the end of January vacancy rates were 6.2% and 6.4% respectively. Both markets benefit from strong underlying fundamentals.

In Sydney, over the past two years, we saw B-grade office rents double, which is clearly unsustainable. With some tenants now paying excess of $1,000 per sqm, flattening is to be expected this year.

The trigger for rapid rental growth was the ongoing withdrawal of B-grade office stock for the Sydney Metro and residential conversions. We don’t foresee major additional withdrawals in the near future, which should keep rental growth capped. At the same time, demand remains strong for A and B-grade stock, and we continue to see suites of sub 1,000 sqm leased before the previous tenant vacates. Vacancy rates will fall particularly in the B grade market however, in our view, both demand and the resulting rental levels are now stabilising.

On the sales side, we are starting to see an injection of new stock into the market. Over the past few years, most owners believed that the office market still had some way to run, and as a result, were unwilling to sell. However, now there is growing divergence in views with some believing that the market may be close to its peak. We therefore expect more stock to come up for sale. This is good news for buyers, who at the very least will be presented with more opportunity and more activity than they have seen in past few years.

Sydney metro markets benefit from stock withdrawals and infrastructure

Sydney metro markets continue to go from strength-to-strength. Withdrawal of office stock for residential conversion in metro and CBD markets has been dominant driver of demand for office space in these markets, and as A and B grade office space has become more scarce and more expensive in the Sydney CBD, businesses have looked to move further afield. North Sydney was the first recipient of overflow demand from the CBD, followed by St Leonards, and now Chatswood on Sydney’s north shore.

Centuria recently purchased a property in Chatswood. This created The Centuria Zenith Fund, which is already proving to be strong performer for investors. Leasing deals are coming in at rents up to 10% higher than we forecast, and the recent re-valuation of our stake in the property saw it rise from our purchase price of $279 million to $301 million – all of which is good news for investors.

The fact that the NSW Government is investing heavily in infrastructure has been a contributing factor to rising demand in metro markets. Parramatta is worth mentioning. Situated in the heart of Sydney’s rapidly growing western suburbs, and with new transport links, Sydney's "second CBD" is now one of the strongest office markets in the country. Quality assets are in hot demand, and this has resulted in upward pressure on prices.

Melbourne is solid, but remains tightly held

Demand for office space in Melbourne is strong. Over the past six months, it grew at 3.5 times the historical average – yet Melbourne continues to be tightly held, and supply is constrained. As a result, we expect vacancy rates will continue to fall throughout 2017.

However, despite the lack of new supply, we expect demand for office property to continue to be strong throughout 2017, as investors seek safe property havens in markets with strong underlying leasing market fundamentals. Offshore money continues to pour in – and we expect offshore groups to dominate the investment landscape looking forward. In 2016, 10 out of the 14 office purchases were made by offshore groups, and this kind of ratio is unlikely to change.

Rental levels have held up well on the back of strong tenant demand, particularly at the Premium end of the market, where landlords have gained some face rental growth. In the A and B sector, however, rental growth has been more subdued, and landlords are finding they need to offer a competitive product to appeal. This means taking an active property management approach – speculative fitouts and upgrading and refurbishing of common areas such as lifts and lobbies have been key to success.

Other markets are struggling, but there are opportunities

Outside of Sydney and Melbourne, capital city markets are weaker. Brisbane, Perth and Adelaide remain weak early in the year. Both Perth and Adelaide saw a sharp contraction in rental levels during 2016 as demand for space fell and vacancy rates rose.

The Perth market is struggling and landlords are offering very significant incentives, in some cases up to 50% incentives to secure quality tenants. Incentives like this are a feature of weak markets, because when there is plenty of available space to lease, landlords compete to attract tenants in one of two ways – by contributing to the tenant’s fitout, or by offering rent-free periods.

On the upside, the Perth Landlords has been saved from complete disaster by on-going low interest rates, which are allowing owners to continue servicing debt despite the poor returns.

The most recent figures from the PCA saw Brisbane picking up. Over the six months to end January 2017, demand for office space grew at over five times the historical average. Nonetheless, conditions remain tough. Money is continuing to flow into the market looking for yield, helping to keep conditions more positive. The fundamentals are weak but should improve during 2017, all of which means we may have seen the bottom and come out the other side!

Little significant change overall

Office CBD markets have not changed significantly since the end of 2016, and our view is that in most cases the fundamental drivers of return have not changed. While Brisbane may have seen the worst and should improve from low levels, Sydney and Melbourne remain our top picks. Given that there is no major new supply in either city (albeit expectation of some new stock in Sydney), we expect to see both markets perform well through 2017. 

 Source: Property Council of Australia

 Colliers International, Research and Forecast Report, CBD Office, First Half 2017

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Will commercial property perform strongly in 2017?

Tuesday, January 10, 2017

By Jason Huljich

Investors haven’t had it easy since the global financial crisis – and real estate has been no different.

A number of both listed and unlisted property trusts undertook highly dilutive equity raisings, collapsed or were frozen as a result of the crisis, leaving investors scarred and wary. Financial markets generally have taken their time to normalise, as volatility became the norm. And to top it off, investment managers have struggled to achieve real diversification in their portfolios as previously uncorrelated asset classes have moved in lockstep, and correlated assets moved apart.

Aggressive quantitative easing (QE) by central banks injected liquidity into global economies as governments attempted to prevent a downward spiral of economic contraction and to stimulate investment and employment. Originally conceived as an ‘emergency measure’, QE has continued for much longer than initially thought, and while it may have succeeded in halting downward momentum after the GFC, whether it has succeeded in reviving real growth is less certain. What it has done is keep interest rates at historic lows - increasing prices for financial assets generally, and punishing savers as bond yields stayed suppressed and investors faced lower real returns and higher volatility than ever before.

The good news for property investors is that against the backdrop of low rates, global volatility and sluggish growth, commercial real estate has been one of the big winners. Falling bond rates and volatile equity markets have driven investors into the stable yields and possibility of upside capital growth of commercial real estate, and in the case of the Sydney office market, offshore money looking for a safe haven has played its part in keeping demand buoyant and prices robust.

So what does the future hold?

Interest rates in the US have now been lifted, and there’s more to come

On 14th December this year, the US Federal Reserve announced a 0.25% interest rate increase, taking official rates from 0.5%-0.75% and calling the move a ‘vote of confidence in the US economy’. In addition, three further rate hikes were predicted for 2017, up from previous expectations of a maximum of two. There was no explicit comment on the US Presidential election, but there is widespread expectation that if Mr Trump follows through on his promise of massive tax cuts and huge infrastructure investment, this could well be catalyst for a more sustained economic recovery in the US, putting further upward pressure on rates.

If rates go up here, will commercial property markets in Australia suffer?

The short answer is probably not. If we look back at what happened in 2013 when the US Federal Reserve Chairman, Ben Bernanke, made the first direct suggestion that the Fed might pull back on its bond-buying program, what resulted was the so-called ‘taper tantrum’. US Treasury yields rose by over 100 basis points in four months which would normally have a negative effect on commercial property markets, but in fact, the effect was negligible. The same was true here.

There is certainly strong long-term relationships between long-term interest rates and real estate capitalisation rates, but there are other, more specific market-based factors at play, not the least of which is supply and demand. High institutional demand, for example, in the face of limited supply plays a very significant role, even in a rising interest rate environment, and this is what we have seen to some extent supporting commercial real estate in the major markets of Australia as well.

Commercial property faces some global headwinds – but they may be to our advantage

Global economic and political uncertainty does present challenges for commercial property managers – because it can mean lower growth generally. And, in fact, the IMF downgraded global growth twice last year, never a positive sign. On the other hand, the impact of global uncertainty can be positive for markets such as Australia, as foreign flows move into markets which are largely viewed as safe haven options.

And as returns from other investment assets struggle, funds which have not been in real estate before are starting to invest. For example, at the end of 2015, after posting huge losses, Japan’s Government Pension Investment Fund announced a move into real estate for the first time – to the tune of US$65 billion. There’s no question that this massive wall of money will provide a boost to some of the larger, or ‘gateway’ real estate cities globally, as it seeks a home in quality commercial real estate. Markets in the US will no doubt be the big winners, but Australia may profit as well.

Sydney and Melbourne could be on the receiving end of significant flows

Our expectation, not surprisingly, is that the most significant flows (both from onshore and offshore) will move into the strongest markets – Sydney and Melbourne.

In Sydney, demand across the board for commercial property has been strong, and as supply has been constrained due to withdrawal of stock for residential conversion, fundamentals have improved. Centuria’s property at 10 Spring Street in the Sydney CBD is a case in point. The property was purchased for $91.6 million three years ago, rented at that time for an average of $620 per sqm. The space is now attracting rents in the order of $1050 per sqm, due to the withdrawal of similar stock and was recently valued at $164 million.

Looking forward, if rates do rise more quickly than anticipated, cap rates could become squeezed, but in our view they are starting to stabilise after a number of years of decreasing significantly.

Commercial property ticks plenty of investment boxes

The bottom line is that the right commercial property investment can tick plenty of boxes. Residential properties are lucky to be making a return of between 2.5-3%, so without some serious capital gains, returns are looking pretty low. This is partly because residential property owners are responsible for outgoings, including council rates, water rates, repairs and maintenance.

By comparison, in commercial property, tenants are responsible for the majority of all outgoings. As a result, yields from quality commercial property can be in the order of 6-8% and when combined with capital growth, total returns are much higher, often 12-13%, or more. For example, Centuria unlisted property trusts over the past 18 years have offered investors, on average, total returns of 13.2%.

Needless to say, a higher return doesn’t come without some risk, and in commercial property, one of the biggest risks is vacancy. But that’s where it’s important to look at the track record of the property manager you are investing with – how well they have managed vacancy across their portfolio in the past, and how competent they are at maximising both rents, and capital gain.

But if these factors are covered, and despite some global economic malaise and the prospect of rising rates, the right commercial property will continue to perform strongly in 2017.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Finding yield with unlisted property trusts

Tuesday, July 12, 2016

By Jason Huljich

It’s the old conundrum; if it sounds too good to be true, it probably is. Higher risk can mean higher returns, but it also means higher risk! At the same time, low risk means lower returns. In an economic environment of near-zero interest rates, many low-risk assets just can’t give investors the income stream they need - let alone the possibility of growth in the future. Let’s take a look at unlisted property trusts and see whether they fit the bill in challenging times. 

Global growth is improving, but the views of the world’s leading economists remain cautious in the extreme. The US Federal Reserve Chair, Janet Yellen, acknowledged this month that she could not rule out the possibility that slow productivity growth will continue into the future. This is despite the fact that she has argued for years that the headwinds to economic growth would fade, allowing growth to pick up and interest rates to rise.

For advisers and their investors seeking a yield they can live on, this kind of rhetoric is unlikely to raise their spirits. But it does signal a need to carefully assess investment and asset allocation decisions. Traditional glide paths which saw investors (in particular those approaching retirement) shift out of so-called growth assets like property and shares, into fixed interest and cash, must now be approached with caution.

So where should advisers and investors be looking?

Unlisted property trusts are one option

The right unlisted property trusts can provide investors with a yield they can live on and the possibility of capital growth in the future. Many invest in high-quality commercial office property, which individual investors would not otherwise be able to access, and active asset management can increase both income yield and potential sale price in the future. On the other side of the coin, most unlisted trusts last for between five to seven years, during which time it can be difficult to exit. But for investors looking for yield, rates of between seven and eight per cent are very appealing.

But not all unlisted property trusts are created equal. Investors can be faced with a difficult conundrum when assessing their options. In property, as in any investment, the more you move up the risk curve (or down the quality curve) in the expectation of a higher return, the more danger. And we only have to look back at the experience of unlisted property trusts in the global financial crisis (GFC) to see where that can lead. In that instance, a heady mix of high gearing, poor asset quality, inadequate disclosure and a lack of transparency from management saw many investors get burnt.  

The trick is to get the balance right – too little risk can leave investors unable to live, but too much can be even more catastrophic.

Look carefully at the manager

One way of mitigating potential risk is to choose an unlisted property manager carefully. If there was one good thing to come out of the GFC, it’s that some of the less scrupulous managers were weeded out. However, despite the fact that the industry has made significant improvements in relation to disclosure, fund structures and fees, it is still of utmost importance to look at a manager’s track record. How long they have been managing unlisted trusts, how have their funds performed over time, and what level of transparency and communication an investor can expect.

Unlisted property trusts closely mimic the performance of their underlying assets, much more than their listed counterparts, A-REITs, which tend to move in line with equity markets. Because an unlisted trust is not priced daily by the market, it is very important that the manager is transparent about how properties are valued, and how the fund’s net tangible assets (NTA) are calculated. There are strict rules governing how assets are priced, the disclosure of borrowings, as well as fees and charges, and a good manager should automatically disclose this information.

Active versus passive asset management

Because returns from an unlisted property trust are so closely based on the performance of the underlying properties, understanding the quality (or otherwise) of the property and its tenants is crucial. A good manager should explain his or her reasoning in this regard.

There are also a number of key figures and ratios which an investor should consider carefully. Some of these relate to the likely income from the property, and others to the potential for capital value. In both cases, the ongoing actions of the manager can make a significant difference to overall returns.

For example, on the income side, the weighted average lease expiry (WALE) of a property is very important. The WALE measures the average time period in which all leases in a property will expire. Given the leases in a commercial building provide the income streams which make up the yield, the length of the leases clearly underpin income returns. Generally speaking, the longer the WALE, the more secure the income stream, and potentially the higher the price of the property when it comes to sale.

Also important is the quality of the tenants in the building, and whether or not there are opportunities to improve the property and increase rental levels. This is where an active manager can play an important role. We have a dedicated in-house asset management team whose job it is to identify ways of managing our portfolio of properties and identifying possible improvement. Upgrading foyers and lifts, improving air-conditioning and even undertaking ‘spec’ fitouts in order to attract smaller tenants, can all improve a property’s profile. 

Never has the ability to identify an appropriate risk/return relationship been more important. Too much risk can lead to disastrous results, but in a world where term deposits can’t put food on the table, investment options which provide a liveable yield are in demand.  While every investor’s situation is different and asset allocation decisions must take into account individual risk profiles and investment horizons, there are many reasons why advisers and investors might consider adding unlisted property trusts to the mix.

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How the Budget will impact property prices

Tuesday, June 07, 2016

by Jason Huljich

The bad news

It’s fair to say that the Federal Budget’s changes to superannuation went further than many analysts were expecting. For some wealthier investors, in particular those with high super balances, or who have been used to contributing large sums to super at preferential tax rates, the changes may prompt a fundamental re-assessment of their options.

The good news

The good news is that negative gearing and capital gains tax were left unchanged – and the Reserve Bank of Australia (RBA) cut the cash rate to its lowest level ever, which on the face of it is good news for property.

At the same time, a recent squeeze on local and overseas lending conditions and some economic malaise has seen some of the heat come out of the property market, in particular the residential market in Sydney, and to a lesser extent, Melbourne.

So will the Budget re-ignite the fire, and if so, is residential property an investor’s best bet?

Residential property – can the boom in capital growth continue?

According to data from the Australian Bureau of Statistics (ABS), residential property in Sydney and Melbourne has risen 52% and 20% respectively since the RBA began cutting rates in 2011.

Other markets have also risen, but by much less, with none above 15%. Over the past year, Perth and Darwin have both recorded negative growth.

With the RBA cutting the cash rate on the back of weak economic growth and low inflation, can house prices really continue to rise as they have been, even in Sydney and Melbourne, which account for 65% of housing stock?

It’s hard to believe. Affordability is the big issue - particularly when you consider that the average increase in weekly income is not rising at anywhere near the rate of house prices.

At the same time, for yield-hungry investors who can see rates on term deposits and other cash-like investments plummeting, the stable, consistent yields from property can look attractive.

But again, it depends on the type of property in question.

And that’s where residential property struggles to compete. Typically, in Sydney, gross yields are in the order of 3-4%, and net as little as 2% once expenses are taken out. That means after tax and inflation is taken into account, unless a large capital gain is assured, the total return isn’t great.

The only hope is that capital gains growth will mirror what has been seen over the past 25 years, again, not a sure thing.

What about commercial property?

In comparison with the residential sector, commercial property had much to thank the Treasurer for. The Budget was business friendly, with a variety of measures designed to encourage employment growth, all of which is good news for commercial property.

Tax incentives for start-ups as part of the $1.1 billion National Innovation and Science Agenda, tax cuts for small business, as well as government employment growth, are all measures which should stimulate tenant demand. This will be particularly positive for Sydney and Melbourne, where new businesses, particularly those focused on innovation, are most likely to benefit.

In addition, announcements about investment in defence ($195 billion over 10 years for defence infrastructure including submarine, frigate and patrol boat building) is all good news for the depressed markets of Adelaide and Perth, where much of the action will take place.

New spending on infrastructure – almost $3 billion across Australia – is good for property everywhere. $115 million for a second Sydney airport at Badgerys Creek, $594 million for inland rail between Melbourne and Brisbane, $1.7 billion from asset recycling for Sydney Metro rail and $857 million from asset recycling for Melbourne Metro rail should all provide a boost to commercial property in these areas.

Commercial property - a favourable tax structure and stable yield

In comparison with residential property, yields from quality commercial property are typically higher (7% – 8%) and more stable than those on offer from residential property. Tenants are corporates rather than individuals, and leases are usually longer, are often indexed to inflation, and income is usually tax-advantaged.

At the same time, for most investors, due to the cost, direct investment in a commercial property is not possible, so in order to access the sector they will need to consider a syndicated structure. The two most common are listed property trusts or AREITs, which are traded on the Australian Stock Exchange (ASX), and unlisted property trusts.

AREITs are closely correlated with equity markets, whereas unlisted property trusts are more closely tied to the performance of the underlying property assets. They are not as subject to market movements (properties are typically valued annually rather than daily) and distribute regular income. On the downside they are not liquid, and investors are usually required to maintain their investment for a period of around five years.

Yields from unlisted trusts can compare very favourably with those from residential property. For example, the Centuria Zenith Fund, which owns a 50% stake in two office towers in Chatswood, will have a forecast distribution yield of 7.6% in the 2017 financial year, growing to 7.7% in the 2018 financial year.

The bottom line?

The changes to superannuation and other economic stimulus measures announced in the Budget mean that many investors are taking the opportunity of re-assessing their investment portfolio in line with their expectation of what the changes will mean for them.

Investors looking for tax-advantaged income which can keep pace with the cost of living, would do well to assess what’s on offer in commercial property.

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Volatile markets? Time to look for steadier performers

Wednesday, February 17, 2016

By Jason Hulijch

Market commentators are united in their conviction that equity market investors are in for bumpy ride this year – irrespective of how they see the ultimate outcome. The reasons for this are much the same as for the latter half of last year: concerns about whether the US Federal Reserve will prove trigger happy when it comes to rate hikes, falling commodity prices and disappointing Chinese growth are all likely to keep markets flighty. On the home front, the outlook for business investment is still weak and the Aussie dollar too high. 

Equities aside, historically low interest rates mean that cash, term deposits and fixed interest are barely feeding the family. 

Against that backdrop, there is a real appetite for investments which can provide a stable, yet reasonable yield, without foregoing the possibility of capital growth over time. 

That’s where property comes in.

The property outlook

Looking at residential property, yields are very low, in the order of 3%, so it’s clear that investors are foregoing income now in the hope of major capital gains later. 

On the other hand, commercial property (including office, industrial and retail), looks like a better option. Yields are more stable and higher, around 7-8% p.a. And indeed, over time, yields from Australian property have proven to be extremely consistent, regardless of the rise and fall of capital values. 

For investors interested in taking a position in commercial property, the most common options are either a listed trust or AREIT, or an unlisted trust. Given current volatile equity markets, an unlisted property trust might be the better option right now. 

AREITs and unlisted property trusts: similar but different

While both AREITs and unlisted trusts often invest in the same kinds of property, the precise mix of assets differs depending on the trust. And, even though the underlying assets may be similar, the structures are quite different. 

AREITs are listed on the ASX and are therefore priced daily by the market. They are closely correlated with equity markets and, like equity markets, the price is influenced by market sentiment and other macroeconomic factors not necessarily closely related to the underlying assets.  

The bottom line is that listed and unlisted property trusts can differ markedly, with valuations and investment returns that do not necessarily move in tandem – even with similar underlying assets.

This means that regardless of the changing fortunes of the properties in the trust, if share markets are volatile, listed property may be volatile, too. For this reason, an AREIT does not necessarily provide full diversification benefits in relation to equities. 

At the same time, AREITs deliver the benefit of liquidity, which means investors can buy and sell units at short notice. 

Depending on the trust, unlisted property trusts are usually priced six-monthly or annually. This means that valuations are more stable and more closely tied to underlying property values. They are inherently illiquid however, with most trusts lasting for between 5-7 years, during which time it can be difficult to exit. 

Unlisted property trusts have the benefit of stable returns and certainty of cash flow, due to the locked in nature of commercial leases.  Returns also tend to be a good hedge against inflation because lease payment increases are usually inflation-linked. And the low correlation with other asset classes means that unlisted property offers real diversification benefits throughout the investment cycle.

Both types of investment have the potential to provide tax effective income, due to the ATO’s favourable treatment of the depreciation of property assets. 

In both cases, returns are very much influenced by a number of eminently more controllable factors; the quality of the underlying core assets and the quality of the management. And these go hand in hand. The ability of a manager to choose quality properties, pay the right price and extract maximum performance over the life of the asset will naturally contribute to better returns from both types of investment.

Volatile markets suggest a tilt to unlisted property trusts

What it comes down to is that property plays an important role in a diversified investment portfolio, and both listed and unlisted property should be considered. 

The big question at the moment is exactly what that allocation should look, like given prevailing market conditions. High market volatility, lower liquidity as quantitative easing ends and economic uncertainty in all its forms are all likely to translate into ongoing market swings, causing associated volatility in the listed space. 

That’s why it’s time to look seriously at unlisted property.

 

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Property - looking outside the residential square

Monday, September 28, 2015

By Jason Huljich

Does asset allocation matter?

During the 1982 to 2007 bull market, many fund managers became less focused on asset allocation at the portfolio level because returns were strong across the board. The GFC changed all that. Now, with low interest rates and low growth, the consensus is that asset allocation is a major contributor to portfolio performance.

What role should property play in the asset allocation mix?

The general view, be it for an SMSF or otherwise, is that a balanced portfolio calls for some property exposure. The question for many SMSF trustees and investors who want to balance their portfolios appropriately is exactly what that allocation should be.

As always, the answer depends on the individual circumstances of the investor and his or her desired outcomes. Here are just some factors that you might consider - which can form the basis of further research.
First, understand that there are different forms of property investment – so the allocation decision is just the beginning. You can choose a direct investment in residential or commercial property, purchase units in an unlisted trust, which invests in different property sectors, or buy a stake in a listed property trust (A-REIT).

These different forms of property investment also perform differently. Many consider A-REITS to be very similar to equity investments, because returns are more likely to mimic those of the share market and may, as a consequence, be less closely tied to the underlying returns from the property itself.

Something else to factor in is that many Australian equity funds already have an exposure to property stocks. This means you may be more heavily allocated to property than you realise, particularly given the very high weighting to domestic equities typical of many Australian investors’ portfolios.

Equally, it’s important to consider the exposure you already have when deciding whether to increase your allocation to residential property.

Many investors feel more comfortable with this sector than others because they own their own home and have some knowledge of the market. That’s why it’s important to understand what the real returns from residential property are. At the moment, for example, residential rental yields are very low, particularly when compared with commercial properties.

For sophisticated investors, an unlisted property fund run by a quality manager is another way to gain direct exposure to property. Because unlisted commercial property trusts are not closely correlated to equity markets, values can be more stable and rental income streams more locked in including, in many cases, with inflation-linked growth built in.

While there are no hard and fast rules about property allocation within a balanced portfolio there are some options to consider once you’ve done your research as to what type and quantum of exposure will suit your needs. Some investment managers would suggest a split between unlisted and listed property, often half and half. And always factor in the likely structure of returns from different property sectors, taking into account both expected yield and the potential for capital growth.

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The fundamental things still apply for property

Thursday, July 02, 2015

By Jason Huljich

Property - a defensive asset with the potential for growth

Listed and unlisted property trusts play different roles in a portfolio, and, in a balanced portfolio, most investors would favour a split between each. Both are good alternatives to bonds or term deposits for investors looking for a strong stable yield and solid market fundamentals over the past year have seen both perform well.

According to the ASX, total returns from the A-REIT sector were over 20% for the last financial year, a great result in the current climate. At the same time, with a number of A-REITs now trading above their net asset value, many investors are questioning whether they have left their run too late. Some commentators have indicated they believe the sector may be overpriced, in part due to the continued demand from offshore players capitalising on historically low interest rates to buy into Australian property.

In the unlisted sector, returns have been slightly lower, but also less volatile. Over the year to April 2015, for example, the unlisted sector returned 16.6%.

One of the reasons for the difference in returns is that the listed sector tends to move in lockstep with equity markets, which have also enjoyed a bull run in the past year. In this respect, the value of units in A-REITs is less tied to the underlying properties themselves, and more to general market sentiment. Whereas units in the listed sector are priced by the market every day, units in unlisted trusts reflect valuations of the underlying property, which usually occur only once every 12 months. In this respect, an unlisted property investment is a more direct property investment. 

For investors tempted by the excellent returns from the listed sector over the past 12 months, it is important to note that according to indices produced by Mercer, returns from both sectors are similar over time, as shown in the table below. 

The ‘downside’ of unlisted trusts is that investors’ money is locked in, typically for periods of between five to seven years. On the other hand, if total returns over longer time periods are comparable, income returns from the unlisted sector tend to be higher, and less volatile – an appealing prospect for investors hungry for yield. 

Listed vs unlisted asset returns

Tax-effective income

Both listed and unlisted property trust structures offer investors tax-advantaged income. Unlike franking credits, where corporations pay tax on their earnings and investors are given a credit for the tax paid by the corporation, no tax is paid within a listed or unlisted property trust structure. Investors pay tax on the income they receive according to their own tax status.

The tax advantages of income from property trusts derives from the fact that property owners are entitled to depreciation and building allowances and receive tax credits for capital works. This amounts to a deferral of tax on income earned until the property is sold. For example, Centuria’s unlisted trust, the 8 Central Avenue Fund, will distribute 100% tax advantaged income for the first three and a half years. Down the track, assuming the property is sold for a gain, the cost base is reduced by the amount of tax-free income, however any profit is taxed at the capital gain tax rate which is lower than an individual’s marginal tax rate as long as the property is held longer than 12 months. 

Investing for growth: the right property at the right price

For both listed and unlisted property trusts, buying the right property assets at the right price is essential to long-term success. And when it comes to commercial office investment, it’s important to look at all the options on the table. Many investors might consider that prime assets in central CBD locations are most attractive, and while this is often the case, there are also appealing alternatives. At the moment, for example, our view is that competition from offshore buyers and major superannuation funds has made many prime properties too expensive, with a negative flow-on effect to rental levels and investment returns.

The right suburban location can also provide an attractive long-term potential for growth. Areas with good access in terms of road, rail and bus links are growing in importance, and the focus on infrastructure by the current NSW government is likely to see a number of non-CBD locations gain popularity. Many boast high-quality tenants, and offer high yields and high total returns. Macquarie Park, for example, is now a more substantial office precinct than North Sydney. It has successfully transformed itself into a hub for global corporations in the high-tech, bio-tech and pharmaceutical industries, and is the headquarter location of choice for 3M, Aristocrat, Astra Zeneca, Canon and Cochlear. 

We also like Parramatta, where there is significant development already underway. Government tenants have been re-locating to Western Sydney from more expensive areas, and the University of Western Sydney is also growing and taking additional space. 

There is also value in Sydney CBD fringe areas, such as Eveleigh, where rents are half of those in the city. This area also has good transport links and proximity to the city, both of which have attracted top class tenants. Our property in Central Avenue, for example, has a weighted average lease expiry (WALE) of almost 12 years, and high quality tenants including the Seven West Media Group and the NSW State Government.  

Management key to property trust success

The bottom line is that both listed and unlisted property trust structures have an important role to play in a diversified portfolio, and the allocation to each will depend on an individual investor’s portfolio and investment objectives. For listed properties, it’s important to factor in a view on equity markets, given the close correlation between the two sectors. 

What remains the same across both structures is the importance of the manager. 

A manager with a strong track record of performance and a reputation for transparency and sound communication is essential. A demonstrated ability not just to buy well, but to add value to the portfolio is key. Returns from the same portfolio of properties can vary widely, depending on the manager in charge. So make sure you choose one you trust. 

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Property investment and the relentless hunt for yield

Wednesday, May 06, 2015

By Jason Huljich

Resi, steady go

There’s no question that the residential property market is running hot, at least in some places. According to RP Data figures, Sydney recorded price growth of 14.5% and 12.4% in 2013 and 2014 respectively, compared with 9.9% and 7.4% from the combined capital cities in the same period. In the March 2015 quarter alone, property prices rose by 5.8%, and activity shows no sign of abating. 

Vendors may be justifiably delighted with capital growth of this magnitude, but for investors looking to residential property for yield, as well as capital growth, the picture isn’t quite so rosy. In fact, once transaction and on-going costs (such as strata levies) are taken into account, yields from residential property fall to around 1-2% net, among the lowest in the world, and anaemic even by today’s standards.

The reality is that returns from residential property in Australia are very heavily weighted to capital gains on sale, and many investors are more than willing to forego low yields in the expectation of big returns at the end. For some analysts, this strategy makes sense. If you believe the current growth in house prices is a sustainable response to chronic undersupply in the market combined with record low interest rates, then low yields will continue to be more than offset by capital gains. On the other hand, if prices are heading to bubble territory in Sydney, and rising only slowly in other capital cities, then it makes sense to look at other property options.

Commercial office property

Take office property for example. It’s true that yields in the office sector have been squeezed along with residential, but they are still around 7- 8% net (i.e. after fees and outgoings). A massive 4-8 times average yields from residential. 

And total returns aren’t too shabby either. According to recent figures from the Property Council of Australia (PCA) and IPD*, total returns from unlisted office property funds were 16.3% pa for the 12 months to end February 2015, made up of 8.4% income, and 7.9% capital gain. Over two years, total returns were 14.1%, and over 3 and 5 years, 12% and 11.7% respectively. 

For investors looking for a more balanced split between yield and capital growth, office real estate has some very real advantages over residential. Yields from office property tend to be more stable, with growth built in. Unlike residential property, (and depending on the property), tenants are usually large corporations rather than individuals, lease terms are long, and rent reviews are fixed at a rate of between 3-5%. In a low inflation environment, this kind of inbuilt growth is very powerful. 

A-REITs versus unlisted property 

For investors looking for office property exposure, but without the means to buy an office building outright, the two most common options are listed property trusts (A-REITs) or unlisted property trusts. Both structures give investors access to either a single property asset, or a portfolio of property assets, however, there are some distinct differences. 

A-REITs can be more volatile than unlisted property trusts, and tend to be strongly correlated to the equity market, so in this respect they are not a pure property play. On the other hand, they are liquid, and investors can access their money at any time.

Unlisted property trusts give a more direct investment in property, unit prices are not volatile because they are based on a valuation of the property assets in the trust, which generally occurs once a year. Money is locked in for periods of around five years and sometimes more.

Clearly there are pros and cons to both structures, and our view is that an investment in both as part of a property allocation within a diversified portfolio is a prudent strategy. 

However, all properties are not created equal, and just as it is important to look carefully at the manager of a property trust, it is also crucial to assess the fundamentals of the property investments made. 

So where do we see value looking forward? 

For us, despite some capitalisation rate compression at the top end of the market, office property still offers plenty opportunity to the astute investor. Having said that, prices paid for premium office towers in the core space have been rising sharply on the back of demand from offshore buyers and the larger A-REITs, and we see this sector as fully priced now. Yields are falling, and we would not be surprised to see a property purchased at a sub-5% yield this year. 

The best value now is to be found in the secondary market, including the metropolitan and B-grade space. A judicious manager can buy well, produce a strong  and reliable yield for investors all while working on the capital gain side of the equation through active asset management over the life of the asset.  It’s a model which compares very favourably with residential property investment at a time when a focus on yield is very much top of mind.

*The Property Council of Australia/IPD Unlisted Retail Property Fund Index, Period ending February 2015.

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Commercial property to outperform

Wednesday, March 04, 2015

Overseas investment into Australian residential and commercial property markets dominated headlines in 2014, and for good reason. According to figures released by Global real estate specialist, Savills, sales in the Sydney CBD office market in the 12 months to December 2014 totaled $4.7 billion, almost double that of the previous 12 months. And foreign investors were responsible for 45% of that total spend.

In 2014, the majority of this foreign capital was focused on two areas: premium grade office towers and development – much of which was conversion of office stock into residential assets.

This year we expect overseas inflows, in particular from China and Malaysia, to continue. Some will be focused on premium office assets in the major CBD markets of Sydney and Melbourne, but residential conversions will also continue. The effect of these inflows is already apparent, with yields down between 25 and 50 basis points over the last six months.

In our view, this trend will continue. Ultimately we expect yields in core office markets to fall from 6-7% to 5-6%. We even believe we could see a sub-5% transaction for a core Sydney asset this year. Despite this, we expect local yields will remain attractive to Asian investors compared to the 3-4% on offer at home.

Onshore demand to ramp up

Demand from onshore players will come primarily from the listed sector (A-REITs) as managers continue to aggressively seek high-performing assets.

Continued scarcity of assets is likely to continue, however there are a number of assets and portfolios expected to hit the market this year. The recent decision by Morgan Stanley to exit the Investa Group, and sell down its estimated $2.5 billion in property assets, has already sparked strong interest among investors. Some of the assets up for grabs are premium, including 126 Phillip Street and 225 George Street in Sydney and 120 Collins Street in Melbourne. It will be interesting to see the sale process unfold.

On the leasing side, we expect improvement in market fundamentals, with increased demand and incentives stabilizing and then reducing.  Savills expects more businesses to be in a position to commit to a new building, having spent the past seven post-GFC years consolidating and working their existing accommodation harder.

Supply pipeline manageable

The bulk of the future office supply pipeline in Sydney will come from the three commercial towers at Barangaroo. The first represents 89,000 sqm of office space and will be ready for occupation later this year. It is almost 80% pre-committed. The second, 78,000 sqm, will be ready early 2016, and is 77% pre-committed. The third, and largest, tower, 101,000 sqm, is due for completion in early 2017, and is only 34% pre-committed.

There have been concerns that this volume of new office space could distort the Sydney market. However, given that Barangaroo represents only around 8% of the office space on offer in Sydney, we think it unlikely. In addition, as Barangaroo comes on line, significant back fill office space will be withdrawn from the market. Some will be refurbished, some re-developed and some converted to residential or hotels. All in all, our expectation is that any new supply, including Barangaroo, will not negatively affect market fundamentals as materially as first thought.

In Melbourne, supply will be more muted as the remainder of the Docklands space is absorbed.

Industrial property benefits from online revolution

We expect a continuation of industrial property’s strong performance this year. Logistics is the buzzword here, as the traditional ‘dirty’ industrial sites make way for larger warehouses to meet the growing demand of online retailers to provide quick and efficient delivery.

Our focus is again on the markets in Sydney and Melbourne, although their different fundamentals will affect both price and performance. Land for industrial development is scarce in Sydney, with the ocean on one side, the Blue Mountains on the other, and a desperate residential shortage. In Melbourne, on the other hand, development land is more available and therefore cheaper.

Asset-specific choices key to success

Ultimately, regardless of the economic factors driving property markets, there will always be opportunities for investors, even in a downturn or a weak market. The key to success is focusing on the fundamentals of each asset, assessing how it is likely to perform within its market and paying a price which reflects its ability to both generate an acceptable income stream and provide the potential for capital gains in the future.

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MORE ARTICLES

Property and SMSFs – a match made in investment heaven?

Three keys to property investment success

End of financial year. Time to change everything. Or is it?

When is property right for an SMSF?

Once bitten, twice shy?

To syndicate or invest directly, SMSFs push into property

A tale of two cities

Quality tenants mean quality returns

Industrial or commercial – where should investors be looking in a low yield world?

Looking for unlisted property?

Extracting value from your property investment

Commercial v. residential: what stacks up?

Commercial property continues to provide good upside

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