Why investors should consider alternatives to residential property
As interest rates fall, making cash and term deposits less attractive to investors, there’s an increased level of interest in property. However, a stampede back into the old stomping grounds of residential property might not be in their best interests, as Mark Pratt reports.
Investing in ‘bricks and mortar’ property has long been an attractive option for Australians, in particular investing in residential housing or apartments.
While investors may be more cautious about property in the wake of the global financial crisis (GFC), and wary of issues within the sector such as the significant losses experienced by listed real estate investment trusts (REITS) through the GFC, the long-term love affair with property investment is returning.
However, investors should consider broadening their horizons beyond residential property as an investment.
Many already have a significant proportion of their wealth tied up in residential property, either as owner-occupiers or through negatively geared investment properties.
Therefore the opportunity to diversify into non-residential sectors of the property market, such as the commercial and healthcare sectors, shouldn’t be dismissed.
One significant benefit of non-residential property investments is that investors can gain access to some of Australia’s largest and most well-known companies as tenants.
For instance, larger commercial property assets, such as office buildings, will often have many leases in place with a diverse range of tenants over multiple timeframes, so the impact on returns of one tenant leaving is minimised.
Furthermore, owners of non-residential properties can often negotiate longer leases – in some cases up to 10 years or even beyond for some private hospitals – with large multi-national companies whose risk of defaulting on these leases can be significantly lower than residential tenants.
This contrasts with residential property, which usually depends on receiving rent from individuals and has short, sometimes six-monthly, lease terms.
The result of the longer-term, contracted rental income from non-residential property is greater consistency of income returns for investors.
Indeed, income returns for direct commercial property have remained steady at between 6 and 8 per cent, even during the GFC, and are likely to remain at around this level, while returns from residential housing are expected to return an average of approximately 2.6 per cent in the years ahead.
Property returns also compare favourably with cash and fixed income investments, which have recently been popular with advisers and investors.
With the spread between property yields and the 10-year bond rate now over 400 basis points, it presents compelling risk-reward metrics over traditionally lower risk bonds.
On top of this, financial advisers and investors who are looking to add yield to their portfolios – while reducing volatility and diversifying away from listed investments – should also consider the opportunities that unlisted property funds provide.
While listed REITs were the best-performing sector in the Australian sharemarket in 2012, some REITs are trading at share prices close to 30 per cent above their book value.
Unlisted property funds, however, always price at their net tangible asset value; that is, the investment price is the fund’s property value less debt, ensuring a far more stable capital environment for investors concerned about volatility.
Investing in unlisted property funds, as opposed to a single investment property or even a single-asset property syndicate, can also provide significant diversification benefits.
The larger number of properties in unlisted funds allows fund managers to construct a portfolio that provides sector, geographic and tenant diversification.
It also allows for continued investment and a greater fund size, thereby offering even greater levels of diversification over time, while providing the opportunity to actively manage the assets – acquiring and disposing of assets to maximise investors’ returns.
Unlisted property funds, unlike single-asset syndicates, also give fund managers the flexibility to construct a portfolio with a mix of key, long-term assets for security and smaller, higher yielding assets to provide short-term liquidity.
It is this flexibility that allows for more appropriate timing of asset sales rather than imposing the constraint of a set timeframe within which to sell assets, regardless of the external market environment at the time.
Other benefits of investing in commercial property include:
- Capital stability: The values of commercial properties are determined periodically by expert property valuers and have historically exhibited lower volatility than other types of investments, such as Australian and international shares.
- Natural inflationary hedge: Rental agreements with commercial tenants often contain provisions for increases in line with inflation or by a set percentage each year. Further, because valuations are also influenced by the level of rent paid, over the longer term commercial property values will also tend to rise.
- Tax effectiveness: Many unlisted commercial property funds distribute ‘tax-deferred’ income as part of their distributions. This is a result of building owners receiving tax credits for capital works completed on their properties. Not only do investors benefit from deferring the payment of tax on this income to when their investment is sold, the tax treatment can also result in investors paying less tax.
Unlisted property has not delivered a negative return over the last 10 years, nor has it shown the fluctuations of the other asset classes.
Healthcare property
One key non-residential property sector that is worth considering is healthcare property.
As an investment, healthcare has long been seen as an excellent ‘defensive’ option because it is less affected by economic cycles than other property sectors.
Healthcare property has a number of attributes that are particularly appealing to long-term investors.
The outlook for occupancy and new builds is very strong, with demand for healthcare services expected to continue to increase based on an increasingly older population and longer life expectancy.
Investment in the facilities that provide the increasing number of health services needed makes healthcare property a growth area, as well as a good defensive investment, and one that should have a place in any diversified property portfolio.
It is also a fast-growing sector that is positioned to capitalise on Australia’s ageing population. Not only is the large baby boomer generation now moving into retirement, as a nation we are living much longer.
The percentage of Australians aged over 65 is rapidly increasing, and by 2020 is expected to make up over 20 per cent of the population.
Australia’s ageing population will have an enormous impact on the economy over the next 20 to 30 years. For example, expenditure by the Federal Government on healthcare is expected to grow from 15 per cent to 26 per cent of total Commonwealth expenditure by 2050.
The Government’s Productivity Commission report highlights the growing need to provide better services and facilities for our ageing population, both in medical services and in developments such as retirement villages.
In addition, the ongoing issues of chronic disease and obesity place heavy demands on Australia’s healthcare system. These demands will need to be met both by government initiatives and by the private sector.
Healthcare property also has the advantage of long and stable tenancies.
For example, when a medical practitioner moves into a centre, they usually make a significant investment in fitting out the rooms and ensuring they have right the equipment and technology, therefore making a long-term commitment to the property.
From an investment point of view, this translates into longer leases, a steady, reliable income stream and capital value stability.
The main areas within healthcare property are:
Private hospitals
Over the next few decades, the role of private hospitals compared to public hospitals will continue to grow.
Forecasts suggest that by 2021, private hospitals will treat 50 per cent of all hospital patients, while day surgery centres are also taking on services traditionally provided by hospitals.
Up to 60 per cent of all medical procedures are now undertaken as day procedures.
Well-located, high quality hospitals continue to be in tight supply and are highly sought after by investors, providing strong support for prices.
Medical centres
The concept of the purpose-built medical centre developed in the mid-1980s from the traditional individual stand-alone doctors’ surgeries.
Today, they are more likely to be free-standing, multi-storey buildings providing a variety of services and are therefore attractive to a very broad range of potential tenants.
Aged care facilities
Aged care covers assistance and support for the elderly and can include long-term care, nursing homes, hospices and in-home care.
The main drivers of the sector include:
- The ageing of the population which increases demand for aged-care accommodation;
- A decrease in the care of the elderly within the family; and
- A greater acceptance of aged-care housing as an accommodation alternative.
Aged-care facilities usually include both high- and -low care accommodation and provide nursing care for patients who have a continuing need for nursing assistance.
The IPD Healthcare Index has shown that while the healthcare property sector is still small compared to others such as retail, industrial or office property, it has performed well over the past few years. As a whole, it has shown a relatively consistent total return profile with a low peak before the GFC and shallow post-GFC trough.
Indeed, the healthcare sector has outperformed all other property on a one, three and five-year basis, driven primarily by strong returns.
Investing in property
Advisers are in the position of being able to assist clients in choosing the best property investment option for them. Some of the areas to consider include:
What management style will I invest in?
- Active or passive?
- Portfolio composition (sector-specific, diversified, single property, multiple properties)?
- Investment approach (low-risk, value-add, opportunistic, development focus)?
- Asset management (direct, outsource)?
What do I want?
- Income / yield (frequency, consistency, how much)?
- Capital (growth, volatility)?
- Liquidity?
- Tax benefits?
- How much risk?
Where should I invest?
- Location (country, state, city)?
- Property sector (office, retail, industrial, healthcare, etc.)?
- Property type (large, mid-size)?
- Tenant (single, multi)?
How will I invest?
- Direct assets?
- Unlisted pooled property fund?
- Listed Australian or global Real Estate Investment Trust (REIT)?
Mark Pratt is head of property, mortgages and capital markets at Australian Unity Investments.
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