Commercial versus residential property

The Australian media has been saturated with coverage of the rise and rise of residential property prices over the past 18 months, particularly the Sydney market and some parts of Melbourne.

There has been talk of property bubbles by the head of the federal Treasury, John Fraser, who told a Senate Estimates Committee in June 2015: “When you look at the housing price bubble evidence, it's unequivocally the case in Sydney”.

Fraser’s then boss and former treasurer, Joe Hockey, however, is on the record as saying that there is no bubble, just a supply problem which the market is in the process of rectifying.

The RBA governor, meanwhile, has said Sydney property prices are “crazy”. What the new Treasurer thinks about this, we will no doubt, hear soon.

In such an environment, what are prospective property investors and their advisers to do?

There is a wave of supply in residential property on the way in Sydney and Melbourne, in the form of new apartment developments.

Goldman Sachs economist Tim Toohey has revised supply forecasts recently, predicting an oversupply of new dwellings by 75,000 units in 2017, a dramatic revision of earlier projections of a 140,000 shortfall.

Given this outlook and the fact the market is looking decidedly overpriced, does one enter the residential property market or look for other property alternatives?

There is a case to consider the commercial property market.

A direct commercial property investment in the form of an unlisted property trust can offer a predictable and attractive return. We are in a low-yield environment that shows little sign of changing for the foreseeable future.

Head of US Federal Reserve Janet Yellen’s refusal to raise rates this month reinforces this outlook.

Five-year bank term deposits are showing three per cent and listed property trusts (REITs) are generally trading at 20 per cent above net asset backing – which results in current yields of under six per cent.

Given this, the opportunity to buy ‘a slice’ or ‘interests’ in direct commercial properties at valuation, receive a running yield north of seven per cent, and a total yield (ongoing yield and capital appreciation) of 10 per cent per annum makes the mathematics look compelling.

Trouble is, for investors the conversation at dinner parties is more likely to be “This house or apartment appreciated 25 per cent in 18 months” rather than “My share of CBD office block is showing me a nice steady seven per cent-plus income with the likelihood of capital growth at the end of the trust’s five-year term giving me a projected total return of 10 per cent per annum”.

In both media and social discourse we rarely hear about the costs involved with residential real estate.

Take a property purchase for $1 million dollars, for example. Minimum entry costs are around $44,000 (stamp duty in NSW – one of the lower rate jurisdiction is $40,811, plus legals, property reports etc).

Exit costs include agent fees (at two per cent of say $1.3 million) at $28,600 and advertising $10,000.

Annual or recurrent costs include insurance, council and water rates and maintenance – this could easily top $4,800 per annum.

With an investment property there is also the annual land tax impost which, in the case of a free-standing house could be around $10,000 per annum.

Goldman Sachs notes that gross returns on residential investment property in Sydney and Melbourne in August were at record lows of just over three per cent. That, of course is before any of the costs listed above.

In short, the very low yield by residential property requires strong capital growth of seven to eight per cent per annum to achieve a total return of 10 per cent per annum.

Compare this to a direct commercial property trust investment that is showing a net income return after all costs of over seven per cent, approximately three times the net income return from residential property.

If a prospective investor is considering direct commercial property trusts, what criteria should be on their checklist?

First is the WALE – the Weighted Average Lease Expiry of a property or across a portfolio of properties. Assuming the annual rental increases under the lease are attractive, the longer the WALE the better.

Second, is the quality of the tenant. A reputable brand or an excellent business with a track record in a resilient sector is preferable to a start-up or obscure/ lesser-known enterprises.

The gearing level of the trust is also important as the higher the gearing, generally the higher the risk. The recommended level is a maximum of around 50 per cent.

Conservative gearing of less than 50 per cent on quality, long-leased properties should see the asset perform through cycles. Higher than 50 per cent is cause for concern, particularly on assets with shorter leases, as a loss of tenant or adverse market movements could seriously erode investor capital.

The key characteristic to note on a direct commercial property investment is it is not liquid. This means such an investment should come from your pool of investible funds allocated to less liquid, or non-cash, investments.

Unlisted or direct property trusts seek to offer a regular stable income and capital growth.

If you are receiving a good return from a quality asset growing in value, except in exceptional circumstances, lack of liquidity should not be a problem as you don’t have the angst of having to find another sound investment.

A clear exit mechanism that puts the decision around exit with investors is critical and should be understood at the time of investing.

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