Getting started in commercial property
Investors are increasingly convinced of the real estate story, attracted by a healthy income return and long-term capital growth without the volatility of the share market. But deciding to invest in commercial real estate is the easy bit; deciding how to go about it can be more difficult, writes Christopher Davitt.
The options available to investors in real estate are dependent on how much they have to invest, but three of the most accessible are direct ownership, syndicates and open-ended funds.
Direct ownership
An enduring appeal of real estate is that it’s tangible and investors often simply like owning something they can see. There are, however, practical limitations to direct ownership that need to be considered.
Property is lumpy and for most investors owning commercial property directly would take up a sizeable portion of their funds.
Let’s consider an investor with a total investment portfolio of $1 million. A quick search of a few commercial property websites shows that $1 million doesn’t stretch very far.
Options include a 50m2 shop in the Melbourne CBD, a 170m2 office suite in central Sydney or a 500m2 industrial strata unit in Brisbane.
Most investors with $1 million would rule out direct ownership of commercial property on the basis that it requires them to put ‘too many eggs in the one basket’.
Even for larger investors, direct ownership of commercial property can be challenging. With a $10 million balance, the properties mentioned still each represent 10 per cent of the investor’s portfolio.
This is a heavy concentration given that each of these properties is only large enough for one tenant, and without that single tenant the property would be vacant and producing no income.
No investor wants an empty property but for some self-managed super fund (SMSF) investors there can also be unfavourable tax consequences if the property isn’t producing enough income.
Furthermore, commercial property requires a great deal of time and expertise to manage even if a property manager is retained.
Finding the right property to buy, appointing a leasing agent, considering any environmental issues and legal action are often beyond the remit of the property manager and therefore left to the owner to sort out.
Investors need to understand the work that owning a commercial property directly requires. It needs an investment of time as well as money.
Syndicates
Syndicates help overcome some of the issues associated with direct ownership. A syndicate is when a group of investors come together – or are brought together by a professional manager – to buy property and sell it a few years later.
By pooling funds together, individual investors can better spread their risk as the minimum commitment for syndicates is commonly as low as $100,000. What’s more, often the syndicate will purchase more than one property in more than one market, which also spreads the risk.
Many syndicates have the added advantage of being professionally managed, which takes the hassle out of commercial property ownership. Of course, this comes at a price.
Costs can include the legal and accounting charges incurred to set up the fund, any expenses associated with initially raising money from investors, debt establishment fees, an upfront entry fee to come into the fund, acquisition fees when a property is purchased, fees for managing the assets, fees for selling the properties and a performance fee if fund returns exceed the target.
Still, syndicates have been well supported for a long time. Many investors see the value of professional management as out-weighing some additional costs.
Another important feature of syndicates is that they almost invariably use 30-50 per cent debt (also called gearing). This changes the risk profile of the investment. When things go well and returns are strong, they will be even stronger if debt is used.
The flip side, however, is that poor returns will also be magnified. The degree of magnification depends on the amount of debt used; that’s to say, the more debt the greater the volatility.
If property is being used to reduce volatility within an investor’s portfolio then it makes sense to keep debt to a minimum; for example, less than 30 per cent.
Syndicates are closed-end vehicles. This means there are four basic phases:
- A capital-raising phase when investor commitments are sought
- An investment period when the manager finds the properties to buy
- A hold period when the properties are held for income
- A divestment period when the properties are sold. This is usually five to seven years after being purchased.
Investors are locked into the syndicate from the time they sign up until the time the properties are sold. The advantage of this structure is that there is no pressure to sell assets during the hold period.
The disadvantages are there is a lot of pressure on the manager to buy property in the investment period, which can lead to over-paying for assets, and there is a lot of pressure to sell during the divestment period even if it’s not a good time to sell.
There is also no ability for an investor to withdraw from the scheme if they change their mind or their circumstances change.
Transaction costs can tally up for real estate investors and this is also true within syndicates.
For commercial properties, stamp duty alone ranges from 5 per cent to 6.75 per cent. On top of this there are legal and due diligence costs to buy the property and when the time comes to sell, typically 1 to 2 per cent of the proceeds are needed to cover associated costs.
There is no way to avoid transaction costs altogether although their impact is diluted over time, which is one reason why property is regarded as a long-term investment.
As syndicates tend to buy and sell properties every five to seven years, investors looking to maintain a long-term exposure to commercial real estate through syndicates can expect to incur these transactions cost several times during their investing lifetime.
Open-ended funds
For investors wanting to minimise transaction costs and maximise diversification while maintaining access to their money in a low-debt vehicle, open-ended funds are a good option.
As the name suggests, these funds don’t have a finite life and are able to accumulate their assets over years, indeed decades. This helps them to minimise the impact of transaction costs.
For example, on a $500m portfolio the stamp duty alone would run into the tens of millions of dollars.
As these types of funds buy assets for the long-term, these costs have long since been expensed and are not paid by new investors. Similarly, as there are no establishment costs, investors don’t pay a buy spread or an entry fee to come into the fund.
The ability to accumulate assets during the long-term also gives open-ended funds greater diversification. In today’s market, a large syndicate might have five to six properties with 10 to 20 tenants.
Open-ended funds typically hold 10-20 properties directly and might have 100-200 tenants on the rent roll.
For SMSF investors with an account-based pension, a well-diversified income stream is very important. In order to
keep their tax-exempt status, these investors are required to annually draw upwards of 4 per cent of their account balance.
In this context, diversification by location, property, tenant and lease expiry profile take on an even greater significance.
The scale of open-ended funds also means that they do not need to use much debt.
The average level of debt held by syndicates is 44.5 per cent, compared to the less than 25 per cent for the Wholesale Australian Property Fund, and some open-ended funds hold no debt.
The distinguishing feature of open-ended funds is that investors can choose when to invest and when to withdraw their money.
To allow this – and for other reasons – most open-ended funds maintain an allocation to listed property securities. This does, however, introduce some share-market volatility to the portfolio.
The good news is that investors have choice. Some funds hold less than 25 per cent property securities; in the middle there are funds which hold a 50/50 mixture of direct property and listed property; and there are also funds that just invest in listed securities, some exclusively in Australia and others focussed offshore.
All these funds are available to investors with as little as $30,000 or even less if accessed via a platform.
Commercial property is becoming an increasingly compelling story. But more than any other asset class, deciding to invest is only the beginning.
The investment vehicle you choose is likely to play a big part in determining how much risk you’re taking on, what your returns are and whether you can access your money when it’s needed.
Christopher Davitt is the fund manager of AMP Capital’s Wholesale Australian Property Fund.
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