Why property diversification is important and how to achieve it
Diversification can be beneficial, but when done properly with the appropriate expertise, it can be exceptional.
This article was published by Livewire Markets on 23 May 2023.
Diversification is often cited as one of the key benefits of investing in property. And whilst it is indeed a benefit, retail investors often only scratch the surface.
Most who invest in residential property do so to diversify away from equities or managed funds. Very few gain exposure to the commercial property market, missing out on further diversification benefits – and opportunities.
Commercial property has different characteristics and behaves differently from residential property. It typically has a stronger focus on cash flow and more consistent long-term income returns. Commercial assets are also valued differently based on the income return they provide to investors – known as the capitalisation (or ‘cap’) rate.
The higher income yields that commercial properties comparatively offer are based on the fact that commercial investors are, in many cases, able to pass on the rental outgoings as part of their rental rates. For residential investments, the owner usually pays land, council rates, and maintenance. For commercial properties, the tenants are typically responsible for these expenses. It is worth noting, however, that residential property is typically unleveraged, whereas commercial is.
Furthermore, lease agreements are usually longer. The typical length of a residential lease is 12 months, whilst for commercial properties it can be five years or more, often with an option to extend after the initial term.
These differences in property types can further diversify a portfolio and increase benefits over just residential property investment.
Further diversification benefits are available via investment in a fund such as the Centuria Diversified Property Fund, which holds commercial properties across different states, asset classes, and lease lengths.
I recently sat down with fund manager Doug Hoskins, who is responsible for the performance and management of several of Centuria’s unlisted property funds and co-head of unlisted funds at Centuria. He discussed how the fund is diversified, how he is viewing the property market, and some of the fund’s recent investments/divestments.
Multiple layers of diversification
As noted above, one of the benefits of investing in a property fund is that by the number and nature of the assets that it invests in, the fund can achieve significant diversification benefits.
Hoskins notes that for the Centuria Diversified Property Fund, the vast majority of investments are in direct property, with some investments in Centuria’s fixed-term unlisted property funds and a small portion in liquid assets – i.e. cash or cash like products.
Within direct property – the bulk of the portfolio – Hoskins and his team diversify by location, with the current split across states being Queensland 47%, South Australia 19%, ACT 13%, Western Australia 8% and some smaller allocations in other states.
The diversification does not stop there, however. The portfolio is also diversified across income streams.
“The majority of our income streams come from multinational, national ASX-listed or government-based tenants, so you are looking for creditworthiness for those income streams”, says Hoskins.
And finally, the last layer of diversification is asset class.
“We’ve talked about geography, we’ve talked about tenant income streams, and now we’re touching on property sectors”, says Hoskins.
“As at 31 March 2023, we’ve got a 20% weighting to industrial. We’ve got a strong weighting into commercial office, at 64%. We’ve got some social infrastructure, at just over 8%, and the rest is predominantly in those liquid assets I touched on earlier”.
Not to put too fine a point on it, but these are layers of diversification that simply aren’t achievable for most retail investors, and indeed anyone who is buying a single asset for their property exposure.
The state of play
When asked about his current take on the property market, Hoskins is mindful that property performs in cycles and that “it has recently been challenging for capital values, but income streams have remained resilient”.
He further adds that the future outlook really does depend “on which property sector you’re looking at”.
Hoskins unashamedly points out that one of the benefits of the fund is that it has investments in multiple property sectors, but again notes that “the underlying market thematic is the increased cost of interest and the inflation that is associated with that”.
“That’s placed pressure on cap rates (discussed above). What we’re seeing is that some property sectors have performed differently and the benefit of the diversified fund is that it has those multiple sectors”.
“Industrial valuations holistically have remained fairly stable to date – what you’re seeing is the market rental growth offsetting the softening in cap rates, which is a strong result”.
Hoskins also points out that the social infrastructure assets (mainly childcare centres) that the fund holds are predominantly CPI-linked “and with the inflation you’re seeing, the rental growth helps with offsetting any effects of increased interest rates to the valuation of the property”.
In order to maintain healthy diversification within the portfolio, the fund has made a number of investments/divestments recently.
As noted above, the fund currently has a heavy weighting to Queensland, so recently it sold a childcare centre at 60 Investigator Drive in Robina, at 5% above book value – “a very good result”, says Hoskins. He further adds that the Robina sale is a good example of “if we think there’s value, we sell”.
The fund is also intending to divest another office asset which is currently on the market, and in addition to these sales the Fund has recently completed the first construction/ development in November last year.
The recently completed asset is a brand new, A-grade industrial facility in Derek, South Australia, purpose-built for the tenant. Centuria established a 15-year lease to a highly creditworthy tenant, improving the fund’s portfolio WALE from ~4.75 years to ~5.75 years
“The industrial sector is showing very strong rental growth and we’re pleased to have it join the fund’s portfolio”, Hoskins said of the development.
The bottom line
Whilst diversification is all good and well as an investment principle, clearly there are layers of diversification.
There is diversification away from one asset class to another, there is further diversification within an asset class, and then there is diversification that comes from specialist knowledge and expertise. The Centuria Diversified Property Fund ticks all of those boxes.
The recent investments and divestments in the fund, along with the existing assets, give investors the opportunity to access a $270 million portfolio of high-quality commercial assets, with an occupancy rate of 98%, a 5.6-year WALE across the portfolio, and true diversification.
(Please note that the figures above are as at 31 March, 2023, and occupancy and WALE are weighted by gross income).
Learn more about the Centuria Diversified Property Fund.