Buying commercial in confidence

PORTFOLIO POINT: Commercial property works differently to residential. Would-be investors should do their homework.

I recently participated in a Eureka Report webinar on the merits of investing in commercial property (click here). With hundreds of subscribers tuning in, there is undoubtedly an interest among investors to learn more about commercial property investment.

My main message for webinar attendees was that being familiar with residential property does not necessarily equip them for commercial property: the dynamics of the market are quite different, and prospective investors should commit to educating themselves about its investment fundamentals before proceeding.

Before I consider the unique features of commercial property, there is a constant across property classes, and that is the application of the purpose test – ensuring you invest in the right property for the right reason.

In the residential sector this is about investing in property that appeals to the majority of tenants and future property buyers the majority of the time, rather than because you think you’d be happy living there yourself. And in commercial property, it’s about investing in premises that are in consistent and sustained demand from the business community both now and in the future.

Part of the steep learning curve for aspiring commercial property investors is the sheer diversity of commercial property types. There is office, retail, industrial and warehouse, infrastructure, hotels and other short-term accommodation, and what is known as special purpose investments such as aged-care and child care facilities.

Each category has its own drivers and dependencies, and performs differently over the economic cycle.

If you’re considering investing in retail property, you’ll want to consider the outlook for the retail sector and make judgements on matters such as the impact of online shopping on the demand for “bricks and mortar” outlets. A prospective investor in warehousing will want to keep an eye on container movements and the rise of just-in-time inventory techniques. For those interested in the office market, the rate of job-growth of white collar workers is a key factor. And a decision to invest in aged-care facilities will consider Australia’s long-term demographics, age-specific lifestyle factors and government policy for the sector.

The array of choice and the individual complexity of each sector shouldn’t necessarily put you off commercial property – as long as you do your homework. Rather, the varied palette that is commercial property can assist you to find the right asset that provides both performance and a diversity that complements your existing portfolio.

Commercial property is also valued differently to its residential counterpart.

Capital growth is usually the principal engine of investment returns, but with commercial property it is rental income and lease quality that underpins the viability of the investment and its capital growth. Consequently, in the selection process rental yield is the key yardstick.

This is in direct contrast with the residential sector, where capital growth underpins the rental yield.

Nerida Conisbee, the national director of research at Colliers International, presented the following graph at the webinar, which demonstrates the contrasting yields for different commercial property asset classes.

Lease arrangements play a central role in commercial property considerations. Typically, the lease is negotiated for a period of three-to-five years, with automatic annual rental increases (usually based on the CPI) written into the contract. The lease often provides the tenants with options to renew an expired lease once or several times, based on pre-agreed renewal options and annual rent rises set at the start of the initial contract.

The purpose of these long leases is to bind good tenants to a property, providing more certainty to the owner. All other things being equal, a good lease adds value to a commercial property in the resale market. A property with good tenants, bound with a well-constructed and lengthy lease, will be worth more than an equivalent property with struggling tenants and/or bound with a short-term lease.

I mentioned the purpose test as a constant of investing across all property classes. There is a second constant: the importance of buying high-quality property. Residential investors know that “cheap” housing in second-rate locations is not going to give them the sustained capital growth they need. Similarly, cheap commercial property is cheap because it is likely to have a poor yield, little prospect of capital growth, and the likelihood that it will be difficult to attract and retain tenants.

The entry level for good commercial property is higher than in the residential sector. In today’s market one needs to be looking at investing at least $1 million to access quality commercial property (compared to about $450,000 to buy a quality one-bedroom apartment in, say, Sydney or Melbourne).

Investors without this level of funds could consider pooling funds with a trusted family member or friend, or invest via a commercial syndicate (see Team investing).

Ultimately, the decision to invest in commercial property should be based on one’s financial capacity and personal circumstances, and should only be pursued once genuine independent advice is obtained.

My own view is that commercial property represents a valid way for an experienced investor with a portfolio of residential property, shares and other investments to obtain further diversification within their long-term investment strategy.

When strategically considered and well executed, commercial property can be a rewarding investment venture, not to mention an adventure in its own right!

Property Q&A

This week:

• Property’s future.
• Brisbane on $450k.
• Should we sell in Point Cook?
• Adviser advisory.

Property’s future

I don’t expect a market crash coming, rather a steady slide that will leave property cheaper at the end of this decade than at the start. During the last decade, banks relaxed financing criteria, allowing house prices to reach unaffordable heights. Now lending has been tightened, the numbers don’t add up any more. With our economy supposedly travelling well, low unemployment and moderate interest rates, our housing market should be going much better than it is. This alone tells me something is wrong and it must be way over-valued. Our housing market has a lot of headwinds and the strongest ones will probably come from overseas; when one borrows short and lends long one has to be very frugal with one’s lending. I hope the mortgage insurance companies are solid.

You’re brave to be making such a bold prediction nine years out. I dispute the often-cited argument that a widespread lax credit approach of banks has been the dominant driver of house prices. This is to ignore the elephant in the room: the significant changes to the Australian economy. Through the deregulation and liberalisation of our economy over 20 years, in conjunction with monetary policy, inflationary expectations have been driven down. The resultant persistent lower inflation allows for lower interest rates. These interest rates are set by the Reserve Bank, not the retail banks. The growth in credit has mostly been about increased competition and banks meeting underlying demand.

The other main factor behind rising prices has been a shortage in dwellings over the past 10 years, with supply not keeping up with population growth and changes in demographic trends. Clearly the causes of high property prices are many. I recommend you read the economist Ange Montalti’s paper on this subject from earlier this year, which elegantly deconstructs the drivers of price growth.

I believe that the prospects for property remain positive as long as inflation is kept under control and population growth remains solid. I cannot be confident in predicting that both these two things will happen, but I’m reasonably sure they will. Unless something totally unforseen happens, I believe property prices will be significantly higher by 2020 than they were in 2010.

Buying in Brisbane

I am a 22 year-old recent university graduate in Brisbane. I have secured a graduate job and I am looking to leave the nest and find my own place. I can reasonably afford a mortgage for a property value of up to $450,000, which puts many properties other than units out of my reach. Can you offer advice regarding units in Brisbane's Southside and what do you look for in a unit and developer if buying off a plan?

Please do not buy off the plan. These properties are invariably overpriced, which mean combined with their lack of scarcity value you are unlikely to see much in the way of capital growth when you come to sell.

The good news is that your budget of $450,000 is sufficient to get you onto the property ladder. It might not buy you a house, but you’ll be able to purchase a quality asset. For this money you should look to buy a one or two-bedroom apartment with car parking in a low-rise block built between the 1930s and 1970s in an inner-south Brisbane suburb. Look for easy access to amenities and a relatively consistent streetscape.

Pay your debt down aggressively and, in combination with the superior capital growth prospects of such a purchase, you should build equity. The apartment can then be a stepping stone to something more ideal for your lifestyle in a few years.

Point Cook

We started our property investment five years ago with a $300,000, three-bedroom townhouse in Point Cook, Victoria. The rental return has been good, with few issues in finding a tenant over time (rent is $295 a week). However, capital growth has been poor: we have only seen a capital growth of approximately $60,000 in that time period. Many other suburbs five kilometres closer to the city have seen dramatic capital growth for similar rental returns. We have a long-term view on property investment but, after reading your advice, we fear that investing in a new suburb like Point Cook was a mistake. Though it is only 20 kilometers from the CBD there is still a huge amount of development to occur over the coming five to 10 years. Are we better selling this investment property and starting again?

A great skill in life is knowing when you need to change course, and then acting on it. To your credit, you have analysed your situation dispassionately, identified the weaknesses, and recognised the solution. Yes, it is time to sell the Point Cook property and start again within 12 kilometres of the Melbourne CBD. You may come away from this experience licking your wounds, but you are clearly a more astute investor for it.

Property advisers

I am a thinking of becoming a first-time investor and have been to the office of A Better Choice and was very impressed with their presentation and explanations on how to buy an investment in an apartment in Melbourne. Can you give me any information on ABC and their business ventures?

I can’t comment specifically on other organisations. However, I will say it’s very important that you and all would-be investors are very clear about your expectations when it comes to engaging advisers.

Ensure that the company you employ has no vested interest in selling you any property or development, that they have unrestricted access to the property market, that they work for you exclusively on a fee-for-service basis and do not receive income from any other source during the investment advisory or acquisition process.

Monique Sasson Wakelin is managing director of Wakelin Property Advisory, an independent firm specialising in acquiring residential property for investors.

Note: We make every attempt to provide answers to readers’ questions, however, answers are of a general nature only. Subscribers should seek independent professional advice for more in-depth information that is specific to their situation.

Do you have a question for Monique? Send an email to monique@eurekareport.com.au