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Tuesday, January 10, 2017
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.
Tuesday, July 12, 2016
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.
Tuesday, June 07, 2016
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.
Wednesday, February 17, 2016
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.
Monday, September 28, 2015
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.
Thursday, July 02, 2015
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
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.
Wednesday, May 06, 2015
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.
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.
Thursday, January 22, 2015
By Jason Huljich
Diversification – the golden rule
The ultimate objective of any super fund, including an SMSF, is to preserve and maximise savings for retirement, so appropriate risk management is consideration number one. And that means spreading investments across a range of asset classes.
Property is one asset class. Just how much should be allocated to property will depend on specific investment objectives and time horizons but, broadly we’d suggest between 20% and 40% as a starting point. Within this allocation, a further breakdown between listed property trusts or REITs and direct property or unlisted property funds should also be considered.
Borrowing to invest – fraught with danger?
Borrowing to invest in property within an SMSF can be a good option for a number of reasons. However, the debt must be kept at appropriate levels. For this reason, the size of the SMSF does matter. There is no hard and fast rule, but our experience is that an SMSF of less than $500,000 should probably not consider borrowing.
In addition, the strict borrowing conditions mean that a limited recourse loan is the only option for an SMSF. This loan structure is designed to protect the SMSF, as the lender’s rights are limited to the property acquired with the borrowed funds, and not to any other assets owned by the SMSF. However, fees and charges can be high. (And also, although any changes will be some time off, the Financial System Inquiry last year recommended that SMSFs not be allowed to borrow.)
The purpose of the investment is also prescribed. The property must be purchased with the sole intention of providing a retirement benefit, it cannot be purchased from a family member or related party, cannot be lived in by a family member or related party and must not be rented by a family member or related party. On the other hand, it is possible to purchase personal business premises and to pay rent to the SMSF at the market rate.
What are the benefits of borrowing to invest?
Borrowing allows for access to higher quality property assets than the SMSF could otherwise afford. In addition, because contributions to the SMSF are taxed at a lower rate, there is more left over to pay back the loan, meaning it can be paid back more quickly. In addition, any income or capital gains from the property will also be taxed at the SMSF’s concessional tax rate.
What are the potential costs?
There are many fees and charges associated with borrowing within an SMSF, which can be significant. These include bank and legal fees, as well as ongoing property management fees. Also, debt brings risk in terms of the value of the underlying asset: if the value of the asset goes down, then the size of the debt relative to the value of the asset rises.
Residential or commercial property?
Many SMSF investors feel more familiar with residential property, so are naturally attracted to this sector over others such as commercial property.
However it is important to assess the pros and cons of each. Investors often own their own home, albeit outside of their SMSF, which means they already have a high allocation to residential property. And the very common belief that residential property will only ever increase in value should be questioned. It’s not always true.
Residential property has its risks. Any increase in the official interest rate usually hits residential markets more severely than commercial ones. Sentiment among homebuyers and investors in residential property can change quickly, and prices move sharply as a result.
Commercial property, on the other hand, tends to more stable – owners and tenants are generally more financially sophisticated and less likely to change course overnight.
Yields from commercial property are higher, currently in the order of 8-9%, compared to 2-3% from residential. In addition, quality commercial properties have institutional grade tenants with long leases, and all outgoings are paid by tenants.
On the other hand, price of quality commercial property makes it out of reach for many SMSF investors. That’s where the option of investing via shared structures, such as unlisted property trusts or their listed counterparts, REITs, comes in. This offers the benefits of direct ownership, including allowing for tax and depreciation benefits to flow directly to the investor.
The bottom line? Investing in property through an SMSF makes sense as part of a diversified portfolio – and no one option is always better than another. It is important to seriously assess your property allocation and choose the amount and type which best matches your risk profile, investment objectives and horizon.
Thursday, November 13, 2014
Any investor can tell you that price is a function of supply and demand, and property is no exception. When there are large numbers of properties available, investors negotiate lower prices, and when there are few opportunities on offer, vendors are more likely to ask for, and receive, higher prices.
For investors seeking to understand which markets and which individual commercial properties are likely to outperform looking forward, the same equation holds true. Supply coming into the market, in terms of new buildings or refurbishments, must be taken into account, as should demand, in the form of the strength of the economy and the likelihood of businesses either expanding and seeking more space, or contracting.
Do the research
There are a number of important reports which investors can use to inform their property investment decisions.
Building approvals, compiled on a monthly basis by the Australian Bureau of Statistics (ABS), collate both the number and the size of new residential dwellings, as well as renovations and refurbishments. Because the data shows intention to undertake building activity, it is seen as a leading indicator of activity. Many investors combine this data with housing finance data, which shows the number of offers by lenders to provide funds. Combined, these figures give a good snapshot of investor confidence in the residential property market.
For investors looking at commercial property, the Property Council of Australia (PCA) compiles office market reports on a monthly basis. These reports look at major CBD markets, as well as non-CBD and regional areas, and report vacancy rates, forecast demand and supply as well as other factors such as capital growth expectations. The data is shown over time, allowing for comparison and context.
By looking at what building is underway and what is expected, the report can forecast the likely amount of supply coming into a particular market. When these levels of supply are compared with historical data about the amount of space the Sydney office market typically takes up each year (demand), it is possible to make a more informed judgement about whether rental demand is likely to be strong or weak, and what the flow-on effect on price will be.
It is important to understand supply levels for a number of reasons. When significant supply is forecast, the effect can distort the market. For example, there has been some concern about the effect on the Sydney CBD market of the Barangaroo development, which will come online in earnest in two to three years. In fact, the July 2014 PCA Office Market Report projects six monthly gross supply in January 2016 to be the highest since January 2001, and over double the historical average. This is certainly something that investors need to be aware of.
In our view, however, given that recent supply into the Sydney market has been tracking below historical averages, it is unlikely that Barangaroo will materially negatively affect the market. Indeed, in the same way that the Docklands development actually invigorated property markets in Melbourne, we anticipate that Barangaroo may well achieve the same positive outcome. Particularly when you consider that it represents 270,000 square metres out of 4.8 million square metres of office space in Sydney, it is clear that as a proportion of the whole, it is not market-changing.
In addition, much of the space is already pre-leased, and we anticipate that some of the older buildings, which will lose out suffer as tenants move out into Barangaroo, will actually be withdrawn from the market for refurbishment, thereby reducing overall supply levels. And some of this withdrawn stock may be converted to residential space, further reducing commercial supply levels.
There are also signs that the NSW economy is picking up, which should have a positive effect on demand. The July 2014 PCA Office Market Report showed that Sydney was one of only two CBD markets to record positive demand over the past six months (Melbourne was the other), and at the same time, Sydney recorded the lowest vacancy rate for July 2014. CBD Landlords are reporting a pick-up in enquiries over the past three to six months, and vacancy rates are now below their historical averages. Incentives remain high, however, although our experience of leasing in the Sydney CBD has been very positive, with 22 new leases signed in our properties in the past 126 months.
Having said that, demand for commercial property in the Sydney CBD is such that it is difficult, in our view, to find value at the moment. There is strong demand from offshore buyers, which has driven prices up, so much so that we have not made a purchase since the end of 2013. However, we have sold 20 regional and smaller assets over the past 18 months, in order to re-direct capital to markets and properties where we see better value.
So what’s the bottom line? Informing investment decisions with hard data, research and analysis is the best guarantee of success and both building approvals data and the office market report from the PCA are both excellent first steps in forming an educated view on the state of property markets in general.
However it is important to remember that the fact certain markets are likely to perform better than others, doesn’t preclude making a successful property investment in a weaker market. It is as important to look at the underlying property asset itself as it is to look at market dynamics. Property is, or should be, a longer term investment option, so buying a property for the right price in a depressed market can be a successful strategy, if it is clear that the potential for longer term value creation is there. Which in turn necessitates an active and experienced property fund manager.