The property for income opportunity
Mark Lumby explores the role unlisted commercial property funds can play within the current volatile and low interest rate environment.
Generating sustainable income from investments is possible in the current economic and market environment — but it is important to ensure assets are put to work in the right way.
With interest rates at historic lows and likely to stay there for an extended period, the traditional option of term deposits is largely ruled out for investors when seeking stable income.
Not surprisingly, many investors have turned to the Australian share market, which has historically paid high dividends compared to share markets overseas.
However, share markets tend to be volatile, with potential for large capital losses — something that investors (particularly those approaching retirement) understandably wish to avoid.
Investing in unlisted commercial property as part of a diversified portfolio is one way to strike an appropriate balance between risk and return.
Ongoing demand for Australian commercial property — from both institutional and international investors — is providing ongoing support for valuations and, unlike the situation in the residential property market, there is broad consensus that the Australian unlisted commercial property market offers better value than many others.
Such investors also see a stable outlook for Australian commercial property and the underlying economy.
Looking ahead, our expectation is that strong investment demand across Australia's commercial property sectors will continue to provide valuation support and leasing conditions will remain broadly positive, particularly in Sydney and Melbourne.
Income returns and capital growth
While there are risks which need to be well understood, commercial property investment offers investors the potential to receive stable and sustainable income returns, as well as capital growth, over the medium-to-long term.
Unlike share markets, where sentiment can be a large contributor to returns, and values change daily, commercial properties are generally independently valued once a year using a rational process that considers economic as well as property fundamentals. Therefore unlisted property values are typically less volatile than their listed counterparts.
As well, income distributions from unlisted property funds are principally sourced from the ongoing rental payments of tenants which create a steady, regular flow of income for investors.
What's more, institutional investors are creating strong demand for commercial property, as well as for infrastructure investment.
Studies show that pension funds and large institutional investors are looking to increase their exposure to property over the next six to 12 months. The reasons for this include the stable outlook for Australian commercial property and the strength of the underlying Australian economy.
The flow on effect of this strong international demand has been broad support for commercial property valuations, as well as capitalisation rate compression for quality, well-located property assets (which generally equates to higher valuations).
A word about the residential sector
While most people automatically think of residential real estate when they think of investing in property, this may not be the best option for them, for a number of reasons.
It is well known that residential property values across many Australian markets have enjoyed strong growth in recent years.
But one of the consequences of this run up in capital values has been that it has significantly depressed rental yields to the point where rental income from residential property is now constrained and limited.
Putting growth aside, when comparing the level of net yield generally on residential property to unlisted commercial property, our observation is that income yield from unlisted commercial property is often more than double the yield from residential property.
Stacking up the returns
Whether or not "mum and dad" investors, and self-managed superannuation fund (SMSF) trustees, should also consider increasing their investment allocation to unlisted commercial property will depend on their circumstances and the investment strategy that suits their individual circumstances.
But it is useful for them to understand the investment decisions of institutional market players. These institutional investors are increasing their commercial property exposure in a measured way to help manage volatility and risk across their investment portfolios.
As the table below shows, over the past 10 years (from June 2007 to June 2016) commercial property has produced higher total returns with lower volatility than Australian shares, global shares and listed property.
Importantly, the outlook for unlisted commercial property is broadly positive, and strong demand domestically and internationally is contributing to increased asset values.
Risk considerations
When investing in unlisted property there are three key risks that investors looking to support their lifestyle in retirement need to consider. Whilst not exhaustive these risks include: liquidity risk, longevity risk, and sequencing risk.
Liquidity risk should be a consideration for investors in unlisted property funds. The nature of direct property assets doesn't support daily liquidity so withdrawals need to be carefully managed by the fund manager in line with the large property assets in order to maximise returns for investors.
While unlisted property funds generally don't provide investors with "at call" access to their investment, the trade-off is that they are generally compensated by stable returns and certainty of cashflow due to the longer term nature of commercial leases.
Quality unlisted property funds will generally provide investors with structured access to their capital (at set intervals) with transparency about the withdrawal arrangements in place — helping investors to manage this risk.
Longevity risk is the risk that someone will outlive their retirement savings and become reliant on the Government pension for support. This is one of the fear factors that many investors face. Ironically, the fear of losing investment capital through market volatility can often lead them to invest too conservatively and actually increase the longevity risk of their portfolios.
Sequencing risk is the risk of an investment experiencing poor investment performance at precisely the wrong time, resulting in magnified negative consequences that are difficult to recover from. For instance, if a portfolio invested in listed markets reached its peak just prior to a person entering retirement — at the end of the retiree's accumulation stage — and a significant market correction occurred resulting in dramatic investment loss, the portfolio may not have enough time to recover as the retiree enters drawdown stage, even when the market eventually rebounds.
For those investors nearing retirement it may be wise to reduce their portfolio allocation to listed equities in order to help mitigate sequencing risk. But instead of reallocating to the traditional defensive asset classes such as term deposits or fixed interest — which could create longevity risk — investors should instead consider the risk and reward profile of unlisted commercial property.
Unlisted commercial property is back on the agendas of many Australian investors as they increasingly search for quality, high yielding investments.
Unlisted commercial property could be the income opportunity that many Australian investors are currently looking for. Given its relatively high returns and low volatility of income and capital returns, it can also go a long way to mitigating longevity risk and sequencing risk.
When used as part of a diversified investment portfolio, unlisted commercial property funds can play an important role in helping investors source consistent, low-volatility income.
Mark Lumby is the head of commercial property at Australian Unity.
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