Why commercial property could be the smarter play.

MMJ Blogger and The Australian | 4 months ago
Why commercial property could be the smarter play.

The love affair with real estate is ingrained into the Australian psyche. You can touch it, see it, drive past it and improve it. But with home prices falling, policy questions over tax incentives and less availability of credit, perhaps the love affair with residential property investment is over. So what does this mean for commercial real estate?

Before I tackle this question, it’s worth discussing how the commercial and residential real estate markets differ.

Real estate is commonly thought of as a homogenous asset class that offers investors the same kind of returns. However, there are crucial differences between commercial and residential that mean what happens in one sector doesn’t necessarily ring true for the other. Knowing these differences provides investors with opportunities to exploit at different points in the cycle.

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One difference emerging at a rate of knots is valuations. The residential sector has entered what appears to be a prolonged downturn in pricing as tighter lending standards and elevated apartment supply levels continue to bite. In contrast, the commercial sectors of retail, office and industrial are continuing to trade at strong valuations, as domestic and global investors extend allocation of more capital.

There are critical reasons for this divergence between residential and commercial performance. Commercial assets typically employ much lower levels of debt, with ASX-listed real estate trusts carrying an average of 30% debt on their balance sheets, versus 70%-plus for residential, which makes commercial asset values far less sensitive to interest rate movements and credit tightening.

The other significant difference is income yields. Globally, there is high investor demand for real estate assets that deliver more than 5% income yields. Commercial real estate in core office, industrial and retail markets is typically averaging 5-7% income yields over a cycle, which puts cashflow immediately into the hands of investors. This compares to less than 3% income yields typically generated on residential, where investors tend to look for more capital growth.

Income yield is a strong driver of investment from pension funds, which are looking at ways to deliver better returns to members.

Despite the differences in these markets, we do expect to see a rise in the demand for commercial real estate in the near-to-medium term as a result of falling home prices.

Australia’s $5 trillion residential market is 40% owned by investors who rent out their product. With mooted changes to availability of debt for investment properties held in self-managed super funds, and proposed negative gearing tax changes, a reallocation of capital to commercial real estate for yield-hungry investors is likely to start soon. And combined with the likelihood of rate cuts and global volatility, alternatives to real estate such as equities, bonds and cash start to look more volatile and returns uncompetitive.

If one thing is certain it’s that more Australians are getting older and need investment products that can deliver a steady retirement income return.

For investors looking to make the switch from residential to commercial real estate investment, there are a few things to consider.

From a commercial perspective, finding income returns means looking through the assets into the markets where they sit and how conditions there can deliver strong rental growth. You want to focus on regions with strong economies, low unemployment, positive business conditions and a diverse variety of tenants. Forecasts from our own research indicate for income return hunters the best results will come from prime offices in most major cities and urban fringes, inner urban logistics and convenience-based retail like stand-alone supermarkets and neighbourhood centres.

Beyond the traditional retail, office and industrial markets, residential investors looking to make the switch to commercial real estate will also benefit from diversification of a wider variety of asset types as the commercial market further deepens. Non-bank lending, student accommodation, build to rent and self-storage will all create more opportunity for investors to diversify and achieve better income returns.