Why investing in commercial real estate makes sense

Owning real estate has long been the Australian dream – and our national pastime. One in five Australians own an investment property and popular culture is jammed with people buying, selling, renovating and decorating.

But in the frenzy for the quarter acre, self-directed investors often overlook an asset class that provides similar returns with less risk and lower hassle – commercial real estate.

What is commercial real estate?

Commercial real estate covers quite a wide range of assets.

Most people think of office buildings and warehouses. But real estate is any land or building that can produce income, so it also includes assets like hospitals, hotels - even self-storage units.

Self-directed investors like commercial real estate because it provides a defensive tilt to their portfolios and diversifies them away from listed equities.

Return profile

Commercial property tends to provide quite a stable return, mainly because a large part of the return comes from income – not capital gains – and is often secured under long term leases with tenants.

As the graph below shows, over the past 20 years, commercial and residential property have provided very similar total returns (10.5% vs 10.8% per annum). But nearly 70 per cent of that total return from commercial property has come from income. That’s almost the polar opposite of residential property, where 73 per cent of the return came from capital growth.

Low volatility

Commercial property’s bias towards income matters when you consider volatility.

Property values rise and fall through the economic cycle - but income tends to be pretty stable, mainly due to the long-term contracts between landlords and tenants that are usually far longer than an annual residential rental.

Capital returns in any given year can be negative or positive – but as shown below, the income return remains positive and relatively consistent year to year.
 

Inflation hedge

Commercial real estate also wins fans in times of inflation, because it provides investors with a natural hedge against rising prices.

There are three main drivers of this.

• Long term leases – in buildings like offices and healthcare facilities - usually have provisions that allow annual rent increases linked to inflation. So as prices go up, so does the rent.
• Short term leases – like self-storage units and hotels – don’t have these provisions. But because the turnover of tenants is more regular – even as quickly as nightly in a hotel – the rent can be adjusted continuously between tenants.
• And unlike most assets, inflation actually protects the value of the building itself by lifting replacement costs – the bricks and mortar and the labour needed to put them together gets more expensive in times of inflation. This restricts the level of new supply and underpins the value of existing assets.

Mythbusting

One of the big myths about real estate is its sensitivity to interest rates.

People think rising interest rates are very negative for the real estate asset class as they make it more expensive for people to borrow and reduce demand.

Surprisingly, the facts disprove that myth.

Real estate performs well when rates are rising because it’s a play on the underlying economy – and rising interest rates are after all merely a feature of an improving economy.

As illustrated below, the past 25 years of data on global listed real estate shows it delivers positive returns in rising interest rate environments 87 per cent of the time. The data also shows it performs on par with global equities during these times.

These factors make commercial property especially attractive to investors who are looking for steady income, such as people stepping back from work to retire.

To learn more about investing in commercial real estate, watch our recent webinar.