Do serviced apartments have staying power?

The drop in interest rates to record lows in Australia has reawakened yield-hungry investors’ interest in buying serviced apartments.

But do their widely promoted offerings of seductive returns and low risk have merit, and should they be part of a diversified portfolio?

The popularity of serviced apartments is growing, with more of them being built than any other accommodation type in Australia. Their number has grown to over 55,000 from around 21,500 since 1987, compared with licensed hotel rooms, which have lifted to 88,000 from 68,000, according to Australian Bureau of Statistics data.

Building momentum

They are performing better as well, reports industry research firm IBISWorld. While other accommodation types have been battered by declining domestic tourism and a high Australian dollar, the serviced apartment market has grown revenue in all but one year in the past decade.

What’s even more astonishing is that their developments are largely being financed by “mum and dad” investors. Indeed, private investors own around 6,200 of Quest’s 7,000 apartments and are the driving force behind the company’s nine properties under development to finish by the end of this year.

“I’ve been absolutely inundated with enquiries [for serviced apartments] – you would not believe it,” said Evolve real-estate agent Rebecca Murray. “I’m getting home from a day’s work then I’m answering responses from serviced apartment vendors up until 10:30-11 o’clock – that’s been my life for the past month.”

Serviced apartments can best be described as a hybrid property investment – part commercial, part residential. While they are marketed on residential real-estate websites, their owners usually hold commercial leases with the operator, who is their tenant. In the majority of cases the owner of the apartment cannot live on the property, though they can sell it whenever they wish.

Guaranteed returns

The terms of the lease come under a variety of forms. Most operators offer a guaranteed return per year for a set period, based on the size and type of apartment. Others depend completely on the performance of the complex, where revenues are pooled and distributed across the operator and owners.

Generally under guaranteed returns the yields are anywhere between 6-8%, with rental payments increasing yearly by around inflation.

Lease terms vary, but usually there is an initial lease term followed by options for the tenants to extend it several times in periods of around five years. For example, a serviced studio apartment run by Oaks Hotels & Resorts in Melbourne’s CBD can now be bought with three years left of its second lease term, with the option for Oaks to take up another five years. If the owner wants to keep the apartment afterwards it will be turned into a standard strata residential apartment, unless Oaks decides to renew the agreement.

The main operators in the serviced apartment market are Quest, Mantra Group and Oaks Hotels & Resorts, but the majority of the market share is taken up by smaller firms.

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The surging appeal from mum and dad investors arises from the perception of serviced apartments as a high-return, low-risk investment, with a steady flow of income and without the hassle associated with typical residential properties.

High-risk, low growth

But director of Wakelin Property Advisors, Monique Sasson Wakelin, takes the opposite view, describing them as a “high-risk, low-return investment” that should be avoided at all costs.

One of her main concerns with them is the lack of market depth, as around 70% of residential property buyers are owner-occupiers.

The pool of potential buyers shrinks even further because the banks treat them as commercial investments and are more reluctant to lend against them. They restrict the loan-to-valuation ratio to around 60% on average, depending on the agreement with management, and don’t include the furniture package – which is included in the price of the property – in their valuation.

In essence the market is limited not only to an investor-only base ready to make an upfront payment, but also to those who are unconcerned with leveraging their property.

“It’s a medium cash flow investment – not a strong cash flow investment – because you need more of your money to buy in,” director of Metropole Property Strategists Michael Yardney told Eureka Report.

“[Serviced apartments] pander to the insecurity of some investors worrying about tenancy and management problems,” he said. “The trade-off is that they aren’t going to get the capital growth that residential real-estate investors have enjoyed in the past.”

Sasson Wakelin says that capital growth is hindered by how difficult they are to sell, that they are typically sold to investors at a premium to their market value, and that they are in unremarkable buildings for which there is little scarcity value.

“Developers often opt to market these types of properties as a serviced apartment because they recognise that the assets have limited attraction to home buyers or to long-term renters,” she said.

Another of Sasson Wakelin’s complaints about serviced apartments is that they are saddled with high maintenance costs as there is more wear and tear associated with short-stay visitors, which lowers the return.

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For example, a two-bedroom Quest serviced apartment in the Docklands costs $512,000, returning $33,287 per annum. A simple calculation from this generates a 6.5% return.

What’s often overlooked by investors are the annual council rates of about $1,000 and the water rates and body corporate fees of around $800 each – cutting the net yield to just under 6%.

Australian Property Investor Databank calculates the average gross rental yield in the Docklands for a residential apartment to be 5.1%.

Other investment models might only require the owner to pay for some or the entire sinking fund levy, and this is why investors need to do their homework as fees can vary greatly.

Despite the many shortcomings in investing in serviced apartments, Yardney insists they have a legitimate position for a small group of investors who are willing to trade off control and capital growth for the perceived security of a steadier cash flow.

“I believe they are better in a small super fund or for an investor who doesn’t have a lot of money rather than a similar commercial investment,” he said. “The alternative would be buying the shop down the street, which will have a similar higher yield, but the shop is much more likely in three years to be vacant.”

He urges investors to steer clear of serviced apartments without rental guarantees because even though they might look cheaper, they take away what are the key benefits of the asset class: a reasonable yield, steady income stream and relatively hassle-free investment.