Re-thinking property investment in the hunt for yield

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?

Real estate is commonly thought of as one, big, homogenous asset class that offers investors the same kind of returns.

However, there are crucial differences between commercial and residential real estate that mean what happens in one sector doesn’t necessarily ring true for the other.

Knowing these differences provides value-hunting investors with opportunities to exploit the market at different points in the cycle.

Differences between residential and commercial real estate

One difference that is emerging at a rate of knots is valuations. The residential sector has entered what appears to be a prolonged downturn in pricing as the impacts of tighter lending standards and elevated apartment supply levels continue to bite.

In contrast, the commercial real estate sectors of retail, office and industrial are continuing to trade at strong valuations, as domestic and global investors continue to allocate more capital to this asset class.

There are a few critical reasons for this divergence between residential and commercial performance.

Commercial assets typically employ much lower levels of debt, with Australian Stock Exchange-listed real estate trusts carrying an average of 30 per cent debt on their balance sheets, versus 70 per cent plus for residential, which makes commercial asset values far less sensitive to interest rate movements and credit tightening.

The other significant difference between commercial and residential is income yields.

Globally, there is high investor demand for real estate assets that deliver more than five per cent income yields and with income yields on commercial real estate in core office, industrial and retail markets typically averaging five per cent to seven per cent over a cycle, this puts cashflow immediately into the hands of investors.

This compares to less than three per cent income yields that are typically generated on residential, where investors tend to look for more capital growth.

Income yield is a strong driver of investment from pension funds who are looking at ways to deliver better returns to members, and this is the key reason why offshore pension funds have lifted investment allocations from an average of four per cent in 2001 to 10 per cent today, with likely more to come.

Strong growth predicted

As a result of falling home prices, we expect to see a rise in the demand for commercial real estate in the near to medium term.

Around 40 per cent of Australia’s $5 trillion dollar residential market is 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 significant reallocation of capital to commercial real estate for yield-hungry real estate investors is likely to start soon.

And combined with the likelihood of interest rates cuts and global volatility, alternatives to real estate such as equities, bonds and cash start to look more volatile and returns uncompetitive.

As more and more Australians grow older, they may require investment products that can deliver a steady retirement income return. The Australian Taxation Office estimates that 54 per cent of super funds are currently in the wealth building accumulation stage, versus 46 per cent in the pension annuity phase. With the baby boomer generation entering advanced retirement in the 2020s, annuity incomes will become the dominant investment strategy, but where to place it in the current real estate cycle is challenging.

Investment considerations

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.

Regions with strong economies, low unemployment, positive business conditions and a diverse variety of tenants typically perform well.

Forecasts from our own research indicate that for income hunters, the best results will come from prime offices in most major cities and urban fringes, inner urban logistics facilities and convenience-based retail like stand-alone supermarkets and neighbourhood centres.

Thinking 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 could all create more opportunity for investors to diversify and achieve better income returns.