Five red-hot property prospects

Where can you find tenants who sign up to minimum three-year leases and pay you rental returns of up to 8%?

PORTFOLIO POINT: Finding strong property yields means looking beyond residential. Here are five places to start looking.

While residential property prices may have stalled for the time being, there’s a lot of action in commercial property with strong price growth and yields on offer. Commercial property fell heavily during the global financial crisis (GFC) but many sectors, particularly office space, are now rebounding strongly.

Many investors are hesitant about a step into commercial property, but it has several benefits over residential, including higher yields.

Chris Lang, a commercial property adviser, says if you’re lucky a residential investment will a earn 5% gross annual return; such outgoings as rates, insurance, and body corporate fees will leave you with a 3.5% net return.

“For the same money – I’m thinking a $300,000 to $600,000 bracket in commercial – you’ll probably get returns of anywhere between 6.75% and 8% net,” Lang says. “That’s because the tenant pays outgoings”.

Lang says commercial property tenants also stay longer than residential tenants. “Generally with residential the average tenancy is nine to 12 months. With commercial you’re not going to get much under three years.

“I have nothing against residential. I’m just trying to interpret where my clients are going to get the best value.”

Most experts agree the hottest commercial property sector is office space due to an undersupply of offices, but there are also other good opportunities.

Frank Gelber, chief economist and director of economics and property at BIS Shrapnel, says the officer sector is offering internal rates of return of 15–20%. “It’s extreme,” he says. “We’re not building enough to satisfy even moderate demand; and we’ve got moderate demand. There will be a long period of tight supply driving up rents and prices.”

Tony Crabb, national head of research at Savills, agrees that office property is the best buy for investors. “The office sector is providing the best value at the moment,” he says. “Rents are cheap by global standards.”

Crabb says financing constraints and the unwillingness of developers to take on risk means there aren’t many offices being built, and that lack of supply, coupled with good demand, means the office market remains very much in the landlord’s favour.

He also notes that yields on offices are at historic highs based on yields over the past 30 years. “That gives us a fair degree of comfort that there’s some good buying out there.”

Lang says one benefit of offices is they’re the property asset least affected by interest rate rises. He cites a report that found that over an 80-year period, there was no correlation between interest rate rises and the performance of the office sector. It was purely decided by economic activity such as supply and demand.

While savvy investors are particularly looking to gain entry into the office markets, they also have their eyes on opportunities in other commercial sectors, including industrial, smaller food retail outlets in up and coming areas, and supermarkets.

Below are the experts’ top five opportunities in the commercial space.

Melbourne and Sydney office

In the short term at least, Sydney and Melbourne are expected to generate the strongest returns in the office space due to a severe shortage.

Lang says the office sector typically operates in peak-to-peak cycles of 18 years. When a peak is reached it takes about six years to absorb the oversupply; then there’s a middle period of six years where people try and decide whether prices are going to increase; in the last six years there’s speculative development which generates oversupply.

But Lang says in their last cycle Sydney and Melbourne avoided a period of oversupply. With the market recovering post-GFC, that means there’s a serious shortage of offices, which is pushing up rents and prices. Lang says vacancy rates in a healthy office market are typically around 5–6%, which gives the market enough slack for businesses to legitimately move space as they expand or contract. In Melbourne vacancy rates are just under 5% and heading towards 4.5%. There are also no major projects in the pipeline.

“We’re going to see really strong growth over the next three years,” Lang says.

Perth and Brisbane office

While Sydney and Melbourne offices will outperform in the short term, the capitals of the resource-rich states, Western Australia and Queensland, are expected to outperform in the medium term. Both Perth and Brisbane have a healthy supply of office space at the moment, which is keeping a lid on price and rental growth. But as their economies continue to grow strongly on the back of the commodities boom, that’s expected to change.

“We like Perth and Brisbane,” Crabb says. “Perth certainly – the mining boom is well and truly taking hold over there. You certainly see some extraordinary growth in the companies over there, not just in the short term but over decades. They don’t have enough space, which is going to keep rents very firm. We still think there’s going to be good buying over there; it’s not a case of having missed the boat.”

He says the Brisbane office market is similar.

Michael Kingcott, head of property investment strategy and research at AMP Capital Investors, said in a recent report that while the resource states are lagging now, their construction cycle is near its end and strong demand for office space should erode vacancy rates quite quickly.

“We expect that by 2013-14, vacancy rates in the resource states will be back to sustainable levels and these markets should start to outperform.”

The big question with offices is how to invest and get exposure to these opportunities.

“You don’t have to have a lot of money,” Lang says. “I recently bought a couple of office sites for $350,000 each. You don’t have to have a million-plus dollars to do it. Obviously you can buy better if you’ve got more money. But you can certainly make a start with something less.”

Crabb says there are many options for investors who want to buy office space, including buying a strata unit. Another way is to join a syndicate.

There’s also the option of buying a listed or unlisted managed fund. But Crabb says it’s important to do your research. “You’ve got to do homework to make sure you’re getting exposure to the market you want and that your investment is likely to deliver the returns you want.”

Supermarkets

One of the most popular and expensive forms of commercial property are retail outlets, but most experts agree that retail will struggle for three major reasons:

  • Australians aren’t spending on consumer goods.
  • Retail outlets are expensive.
  • Rents on retail outlets are already high, which is likely to hinder future rental growth.

“Retail is on the nose,” says Crabb. “That may well in itself provide an opportunity, but we think some aspects of it are expensive and will probably stay expensive because it’s a highly sought-after asset class.”

But he believes there are opportunities in one retail sector: supermarkets. “My personal favourite is supermarkets,” he says. “Food prices are going up all around the world. When food prices go up, supermarkets’ prices have to go up, turnover goes up and rents go up. People have to buy food.”

Crabb says supermarkets have favourable supply and demand dynamics. “It’s not easy to just go and keep building supermarkets,” he says. “They’re not prone to being cannibalised by the internet. People continue to go and do their weekly shopping.”

Supermarkets do come up for sale, but generally start at $5–10 million. That puts them out of reach for most investors. But there are other alternatives. Crabb says you could put together a syndicate. Alternatively, you could invest in a property fund that has a lot of exposure to supermarkets. He says the Charter Hall Retail REIT (real estate investment trust) has high exposure to supermarkets, as do the Centro MCS syndicates.

“There are all sorts of investment opportunities out there,” Crabb says. “Supermarkets are probably the better one.” Indeed, he says if you’re going to buy retail, make sure it’s in a street with a supermarket. “If it doesn’t have a supermarket in it, you’ve probably got to be a bit careful.”

Up and coming areas

Chris Lang believes too many commercial property investors are overly focused on inner suburban strip retail. “That’s all they want to buy,” he says, “but you’ve got to think laterally; some of the best retail locations for the small investor would be in new residential subdivision.”

Lang says when a massive residential subdivision is 30–40% complete you start seeing the major retail chains, such as Bunnings, KFC, McDonald’s and Gloria Jean’s launching stores.

“Look for the appearance of chained networks,” he says. “There comes a tipping point where population is sufficient to support the likes of Gloria Jean’s, Nando’s, KFC and Bunnings. Once that happens you know it’s time to start thinking about buying something.”

Lang says the average investor is unlikely to be able to buy a commercial building that houses a major retail outlet. But when the biggies like McDonald’s arrive, other retail outlets such as corner pizza and fish and chip shops emerge to feed off their foot traffic.

The new residents also provide a major source of customers. Lang says savvy investors look at those types of retail outlets as investments. But he warns that he’s not talking about investing in “specialist comparative” retail such as gift shops or fashion stories.

One benefit of an up and coming area is a lower entry point for investors. Lang says the developer most likely bought land cheaper because it’s a new subdivision, so will be able to sell it at a figure 20–30% less in value than some in a more established area.

Lang says it differs from region to region and depends on the size of the shop, but investments would be available in the $300,000 to $700,000 price bracket. He says because it’s not prime retail, you might get a 5–6% net return, though you might do a bit better if it’s new.

Industrial

Like offices, the industrial commercial property sector is also on the rebound, which is throwing up good opportunities. “You can buy good quality industry properties now at a good yield,” BIS Shrapnel’s Gelber says. “We’ve had a correction and yields are now sensible. Rents need to rise a bit more and will.”

Like other commercial property, industrial fell sharply during the GFC. It bottomed in 2009.

“It’s recovering,” Savills’ Crabb says. “It’s well and truly on the recovery path. It fell, along with everything else from the top of the GFC at the end of 2007. It fell right through 2008 and bottomed in early 2009. But it’s been recovering ever since.” Crabb says industrial warehouses are delivering yields of eight to nine per cent, which he says is fair value.

Another benefit of buying warehouses is their relative lack of complication. “Essentially it’s four walls and a roof,” Crabb says. “It’s a very simple building; it’s unlikely to cause you any structural problems – it doesn’t have lifts and so on. You tend to get one tenant in the building and they tend to be there for a long time. The buildings have got a long life. It’s a fairly uncomplicated affair. It suits a lot of people to get industrial.”

AMP Capital Investors’ Kingcott, in his recent commercial property report, said 2011 was a “good cyclical re-entry point for investment into the industrial sector”. He likes single tenanted warehouses close to ports or in central metropolitan areas with good infrastructure links. “In our experience, these are the best assets that can maintain occupancy and income throughout the whole cycle.”

Kingcott said the strongest performance is expected in the resource states and landlocked areas close to major infrastructure such as South Sydney. “Rising fuel costs and emerging changes in supply chain management also point to increased demand for more centrally located facilities in the future.”

This article was first published in Australian Property Investor and is reproduced with permission.