More to property than residential

For many getting a foot on the property ladder is about buying that first residential asset, but when it comes to the return they are looking for from their investment, commercial property may be a better fit.

While investing in residential property has a familiarity that many investors may feel comfortable with returns from industrial, office or retail property investments may come in a more suitable fashion depending on the financial goals investors want to achieve, experts believe.

How would you like your return?

When it comes to property investment, AMP's Capital Wholesale Australia Property Fund fund manager Chris Davitt, explained that people need to consider how they want to earn a return on their investment.

"If you're thinking about property you probably want a combination of income and capital gain, and most people think about residential property first, because it's accessible, familiar and lower lot sizes etc…" he said.

"The thing about residential property is that over the last 30 years or so, about three-quarters of the return have come in the form of capital gain.

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"People have done very well out of that, but very few people are investing in residential property because they think the income returns are great, because they're not, they're two to three per cent … whereas commercial property is the flip.

"The long-term returns have been about 10 per cent, but you get about 75 per cent of that in the form of income… so basically inflation has come in the form of capital gains.

"If income is what you're after it probably makes more sense to have a think about commercial property as opposed to residential."

Charter Hall, Head of Direct Property, Richard Stacker, echoed Davitt's views on the income returns available through commercial property.

"You're not relying on a lot of capital growth to achieve the return you want out of an asset, compared to other asset classes like equities," he said.

"We know capital growth is obviously less certain than if you've got long-term leases to tenants — you know that that income will come in."

Hedging against inflation

On top of providing a steady income stream, Stacker says that commercial property enables investors to hedge against inflation and other factors that cause volatility in other asset classes

"What you'll find with property, because it's a hard asset, that as underlying inflation rises, the cost of building a new building goes up and that tends to help you hold valuation, because inflation is increasing the costs of building elsewhere is going up," he said.

While the structure of commercial property leases enables investors to hedge against inflation, it also shelters them from the fluctuations in interest rates.

"Most leases in Australia are either tied to CPI [the Consumer Price Index] on an annual basis, or they have fixed increases running through the lease, so your income is tied to an annual increase," he said.

"(For) a lot of other asset classes, if you're in cash for example, that's not the case, you're at the mercy of what happens with interest rates going up or down."

Accessing commercial property

While a steady income stream is appealing to many, cost is a significant barrier to entry for most investors looking to go it alone in the commercial property space, according to AMP's Davitt.

"The difficulty with commercial property is that it's expensive," he said.

"You're going to get into a small unit for $2/300,000, depending on where you are, but with commercial property $1 million is really the minimum ticket size.

"That would buy a very small 40m² office suite in the Sydney CBD, a coffee shop in Melbourne, or a 500m² industrial unit in Brisbane… all of those properties can only accommodate one tenant and then you've got a lot of risk just because of that concentration."

While the high cost of entry could be seen as a barrier, Davitt said syndicates and investment funds provide investors with an alternative route to accessing the returns offered through commercial property.

Davitt said syndicates enable a group of investors to buy larger properties without having to overly expose themselves to one asset through a "unitised structure".

"The money is pooled and they might buy a couple of commercial properties or a couple of industrial buildings etc… and that way you're getting a better diversification," he said.

"You don't have to put $1 million in, you can put say $50,000 or a minimum [entry] level, and you get commercial property, but you get it in a more diversified way and also with a professional manager, which is helpful, because you don't have all the time requirements that you would in managing it yourself."

However, there are a number of drawbacks to those investment vehicles, with many having debt of 40 to 50 per cent and investors are tied to the assets for a fixed period before they can get their money back, Davitt said.

"[In a syndicate] everyone gets in together, they're on the journey together, they sell the assets and get their share back together," he said.

Open-ended funds give investors the opportunity to enter and leave the fund without having to wait until the fund closes, while enjoying the benefits of scale and exposure to different markets.

Breaking down commercial property

Within the commercial property sector there are numerous asset classes, with industrial, retail, and office forming the three largest categories, offering investors different income to capital gains returns.

"Generally industrial will give you a higher income return and a lower capital return," Davitt said.

"More expensive properties tend to have lower cap rates and the hierarchy tends to be that industrial has the high cap rates and the higher income return, then you've got office and then retail."

Industrial

In the current climate, Stacker believes the "property fundamentals for industrial [property] are very good".

"The demand is at the 10-year average from tenants, but the supply is actually 15 per cent below the 10-year average," he said.

"So you've got a situation where demand is strong, but the amount of new supply coming into the market is actually lower than what normally happens and that's a good place to be in property.

"It normally means you're going to get rental increases in valuation."

However the supply and demand issues are not the only issues creating positive returns for investors in industrial property, according to Stacker.

"As a sector it's somewhat benefiting from what's happening in the retail area," he said.

"If you think about how online retailing has been increasing its share of the total retail pie, it needs to be distributed from somewhere and that's normally an industrial logistics property.

"So we've been very much focused on that part of the market, which is obviously helping industrial [property] perform quite well."

Suburban shopping centres

While online shopping has boosted the need for more industrial space, Stacker said neighbourhood and sub-regional shopping centres anchored by food-based retailers were still a good investment.

"It's harder to buy food online," he said. "If you think about what you're buying from Coles and Woolworths online, it include perishables and non-perishables, so you need to be at home to collect them and at the moment the efficiency of that model really isn't there."

Largely unaffected by the emergence of online shopping, Stacker believes that the sub-regional shopping centres anchored by the likes of Coles, Woolworths and Aldi, also benefit from the inflation of food prices.

"The reason why we've focused on that as an opportunity for investors is that if you look back over 20 or 30 years in retail, food has grown at about three per cent a year, whereas clothing has grown at zero per cent," he said.

"What that tells you is the cost of buying clothing hasn't actually gone up with inflation, it just means you've got to sell more - your turnover has got to be higher to keep your sales and the same level.

"But if you look at food, just because you've had the inflation impact at three per cent running through it you don't have to increase it at all, but you're also getting population growth at the same time, so you're seeing food-based retailing growing at four per cent a year."

Office

As with all assets, commercial property is impacted by supply and demand, however, this issue has two aspects to it - the demand from tenants and the demand from the investment market, Davitt explained.

"Those things can be quite different, so you could argue at the moment that things in both the office and retail markets are pretty tough," he said.

"It's hard to hold onto your tenants, it's hard getting new tenants, and that's being reflected in the vacancy rates in the office space around the country - they're generally north of 10 per cent in all the major markets.

"That's a sign that things are quite weak, but on the other hand, the demand for property is very strong. It's strong from listed property trusts, it's strong from the wholesale vehicles and it's also strong from offshore investors.

"The simple reason for that is that the yields are pretty strong relative to interest rates both in Australia and overseas.

"So if you've got interest rates at zero or near nothing in the US and Japan and you put your money in the bank you won't earn anything on it, versus coming to Australia putting your money into property and you get five to seven per cent as an income return depending on where you invest your money, plus you've got the prospect of capital growth — that looks attractive even though the occupier markets are weak and hence prices go up."