The best of three: Liquidity, yield and capital growth

Can you achieve these through commercial property investing?

Jason Huljich, Joint CEO at Centuria Capital Group shares his thoughts on rebalancing tactics for 2022.

As Australia, and the world has navigated a turbulent two year period, marked by a prolonged pandemic, lock downs, border closures and significant behavioural shifts commercial real estate has continued to demonstrate its resilience and ability to deliver attractive returns to investors.

The narrative has begun to shift from ‘lower for longer’ to ‘capturing growth’ and managing inflation. Whilst commercial real estate has benefited from capital growth as interest rates and return expectations have lowered, the next period will highlight how investors can capture growth at the income level.

Importantly, over time, real estate has long been considered hedge against inflation. As costs of building new supply increase, rentals for existing building should also follow suit. Additionally, commercial property leases typically have annual rental escalations, often linked to CPI which allow the rental income to grow over time, supporting the value of assets.

When we are talking to advisers and investors, they indicate that their property allocations usually make up somewhere between 15-30% of their portfolios. Recently we have seen a significant increase in demand for our unlisted property funds, driven by several factors, but one clear one being the desire for regular and relatively stable income. At present SMSF investors account for up to 60-70% of Centuria’s inflows into our Property investment offerings. Unlisted property funds are one of the few asset classes distributing monthly income above 5% p.a. and depending on an investor’s appetite for risk, this may compare favourably to other asset classes. The benefits of unlisted property funds stretch further.

They are considered less volatile compared to listed property investments, as you are less affected by day to day market sentiment, however, this should be considered against the fact that unlisted funds have lower liquidity than listed securities. Still, there are several approaches to property investing that may help investors achieve the best of three.

How to invest in property

Direct property investments

It is possible to invest in direct property through your SMSF. As with any investment, however there are benefits and pitfalls to be aware of.

The benefits of investing directly in property through your SMSF

• 100% of the SMSF money can be invested in commercial real estate which can minimise your business’ overheads and maximise cashflow long term
• A member can borrow money to purchase commercial property through an SMSF, but the purchased property will only be available to the SMSF fund
• Tax on rental income is only 15%, and capital gains tax just 10%, if the property is kept for more than a year, so there are some distinct tax advantages to using your SMSF to purchase your business premises
• Your business can rent the commercial property you invest in through your SMSF
• Your business can then pay rent to your SMSF, not a landlord.

The pitfalls of investing directly in property through your SMSF

• High cost of entry to buy quality asset. As a high proportion of super monies would need to be used to invest, this limits the potential for diversification of your SMSF
• High initial investment requirements via deposit
• Need an exit plan in place for the property for when you retire so you don’t end up with a liquidity crisis (unless it is paying enough rent to fund an income stream)
• You need to have done your research to buy in a location that will be able to be rented throughout the lifecycle, and has the potential for capital gains, i.e. you need to become an expert in the commercial property market
• Tax losses from the property cannot be offset against your personal income tax
• You need to appoint a property manager and will pay fees for this service and trust that they will be reputable and do the right thing by the owner.

Unlisted closed-ended property funds

Let’s look at the unlisted fixed term funds first. Investors like to invest in these because they can choose the actual asset they are investing in; it’s not a portfolio that keeps growing so they know exactly what they have got; they can do their own due diligence on the tenants and the building; and so forth. A lot of these investors choose to gain diversification by investing in a number of these single asset unlisted funds. The distributions are paid monthly so the fund is generating an attractive regular distribution. Commercial leases usually have a lease term of three to ten years and depending on the property or tenancy profile; tenants may include government, ASX listed or blue-chip companies. Hence some investors say they like the diversification of property as well as the stability of income.

High net worth (HNW) investors do sometimes look to buy a small property themselves, but some can find it difficult as it’s a very competitive space, especially in that $2-5 million price range. Whereby with single asset unlisted property funds, all investor types can enjoy exposure to high quality institutional grade commercial property ($100m – $200m), with high quality tenants through a smaller minimum investment entry point (generally around $50,000). So, what investors seem to like is that they can get blue chip tenants, institutional grade property and it’s a lot easier to invest than trying to find their own smaller investment property.

Some investors wrongly compare these funds to residential property investments, but the benefits compared to residential include: longer lease terms (sitting at between 3-15 years as opposed to six months to one year); and reduced overhead costs (unlike a residential tenant, the commercial tenants pay for all the repairs, maintenance, property management fees and rates in the building); and of course net distribution returns that will often compare favourably (after factoring in gearing).

Unlisted open-ended property funds

Another way to access the property sector is through unlisted but open-ended investment vehicles. We have a couple of these types of property funds. They have the benefits of unlisted  investments, combined with some of the benefits of listed funds, whereby they hold a portfolio of properties, are always open, have daily unit pricing and limited quarterly redemption features, so they do give investors some limited liquidity if they do wish to get out of the investment, which for some is an attractive option. Because we typically hold 10% in liquid products to allow for the redemptions, they will return slightly lower yields (5-6%) compared to a closed ended five year unlisted asset, but still offer attractive returns.

Listed property funds

Put simply, Australian Real Estate Investment Trusts (A-REITs) pool the resources of investors together to buy a range of property assets, which the trust then manages for a profit. They generate most of their income through rent, with the lion’s share then returned to investors via distributions.

Centuria have two ASX listed sector specific A-REITS: an office A-REIT (ASX:COF), with 23 high quality office assets located around the country and an industrial A-REIT (ASX:CIP), with 80  industrial/logistics buildings throughout the country. The benefits of these are that because they are sector specific A-REITs an investor can choose the sector they want exposure to.  Centuria also has a NZX listed REIT in New Zealand (NZX:APL).

Investors prioritising liquidity above yield in their ‘best of three’ approach, tend to be drawn to the listed property investments. Both industrial and office property, A-REITs in particular have seen  significant changes across Australia over the years. Consumer behaviour, economic trends and changing expectations and priorities in people’s lives and work are really altering how fund managers select the right properties as part of their REIT portfolios.

Let’s look at these and what it means for investors today looking for sustainable income streams.

Summary

The Best of Three – Liquidity, Yield and the potential for Capital Growth: Can you achieve these through commercial property investing? We believe you can. When looking at your 2022 portfolio rebalancing, will a 15-30% property allocation increase for those that understand the property market? We think so, as property will play an important role for investors of all profiles in this lower for longer environment.

The benefits of accessing the property market via different investment types can be summarised as follows: