By Jason Huljich

Real estate investment has performed very well across the board for investors over the past few years. But depending on what investors are looking for, not all property investment is the same. If you’re looking for a yield to live on, commercial property may just be the answer. 

For many investors, and particularly those in or heading towards retirement, yield can be everything. Capital growth is important, but it’s the yield that makes the difference between living on the returns from your investments and drawing down on capital too soon. But with interest rates at record lows, returns from low-risk assets like cash and fixed interest are pretty grim, and investors are facing up to the reality that they need to look at other asset classes to achieve the returns they need.

Residential property can provide stellar total returns – but for how long?

According to a 2016 Long-term Investing Report produced by the ASX and Russell Investments, Australian residential property has been the top performing asset class over the past 20 years. Yet at the same time, in our low-growth, low-return world, Australia’s commercial property sector – including office towers, industrial facilities and shopping malls – has also delivered standout returns.

In fact, data produced by the Property Council of Australia shows that as at March last year, the average annual return on commercial property was 14%, excluding leverage. Add in leverage, and the returns look even better. These are figures which compare very favourably to the 9.2% from listed property and the depressing 1.6% from fixed interest.

Unlike residential property, in commercial property, rental returns drive the results. Average income yields on the $160 billion of commercial property in the Property Council’s index was 6.6%, whereas in residential property, the picture is very different. Residential rental yields in Sydney and Melbourne are at all-time lows: just 2.8% in Sydney and 2.7% in Melbourne as at January this year.

The seemingly endless upward trajectory of residential property prices (in other words, capital growth), has been the major factor driving its great performance. But continuing to bank on massive capital gains to make up for very low yields is starting to look like a risky strategy. Tax-driven investment strategies, like negative gearing, have played a role in propping up the market, but plenty of analysts are now predicting that the tide is about to turn, or at the very least stall.

So where investors should be looking for their property exposure?

Commercial property can offer a better yield/capital growth ratio.

Investors looking for a yield they can live on, without foregoing the prospect of capital growth, could do a lot worse than commercial property. Most investors are not in a position to purchase a commercial building outright – but there are other, pooled investment options which might appeal. Unlisted property trusts are one.

Unlisted property trusts pool investors’ funds to purchase one or more properties. Investors buy units in the trust, which is managed by a professional property manager, with investors’ money remaining in the trust for a specified time period. At Centuria, the period is usually five years, with an option for a further two years if unit holders agree. Investors receive monthly income distributions (yield) from rent throughout the life of the trust, and any capital gain achieved on the sale of the property is distributed when the trust is wound up.

The good news is that the yield/capital growth profile of commercial property can be very attractive – but it does depend on a number of factors.  Chief among them is quality of the property itself, but the quality and track record of the manager is equally crucial.

Factors which impact returns from a property asset

The quality of the property and whether it is fit for purpose, i.e. will the property perform well in its market/compared with comparable products?

- Location, Location, Location.

Weighted average lease expiry (WALE). This is a measure of the amount of time that leases are locked in across the property. Depending on the property and the manager’s intention, a long or short WALE can be equally attractive. Where a property does not need a great deal of refurbishment and is tenanted by quality businesses or government departments, then a long WALE is preferable. However, some properties offer scope to be upgraded and refurbished and rents raised as a result. In this case, a shorter WALE may be better, because it means that when existing tenants leave new tenants can be brought in at higher rents.

Tenant profile. In most cases, quality corporations and businesses with a track record are more attractive than start-up companies, for example, because investors have more comfort that rents will be paid.

Factors to consider when assessing an unlisted property trust manager

The manager’s track record. A track record of success is a positive sign, and while not a guarantee, it's a good indication that future success is likely. Experience in property markets and in managing unlisted trusts is important.

Whether or not the manager is an active property manager. At Centuria, we are active managers. This means we actively seek to add value to the property assets and back ourselves to generate attractive total returns as a result. We do not use external property managers, but rather an in-house team which is close to our tenants, and knows our properties inside out. We see this as our competitive advantage – our ability to buy well and then really work our assets to get the best out of them.

-The trust structure itself. Look carefully at how the trust is structured. Is it clear when the trust can, or will be, wound up? Is it clear when distributions will be made? What is the gearing level of the trust? How well, and how often, does the manager communicate with investors?

Unlisted property trusts – some examples

We have a long track record in unlisted property trusts. To date, we have completed 33 unlisted funds – with an average return to investors of 13.2% per annum.

At the same time, not all our unlisted property trusts are the same, and our strategy with respect to different properties is reflected in different structures and outlooks for the trusts themselves. 

Sandgate Road – a bond-like structure, with better yields than bonds

Sandgate Road Fund is a ‘passive’ unlisted trust and, in this regard, is somewhat bond-like in its structure. The property does not require refurbishment as it is only four years old, offers a long WALE (9.4 years), is 100% occupied, with 81% of the space leased to State Government-owned entities.

This means that income distributions are locked and fixed, in the same way that bond yields are.

The term of the trust is six years and forecast distributions are 6.5% initially, increasing to 7% in the 2019 financial year – with additional rental growth forecast to increase distributions to 8% by the 2023 financial year.

Zenith Fund – active management in a strengthening market

The Zenith Fund – which co-owns the Zenith, an institutional grade office tower in Chatswood on Sydney’s lower north shore is arguably higher risk, but we believe has more potential upside than Sandgate.

The property required refurbishment when it was purchased, and we are about to undertake $27.8 million of capital expenditure to improve amenities. Zenith was 94.8% occupied at purchase, but with a WALE of only 2.7 years.

Given our view that metro market of Chatswood is set to benefit from falling vacancies and strong rental growth, partly due to State Government investment in infrastructure in the area, the lower WALE was very attractive.

We have already been able to raise rents for incoming tenants, and anticipate further rental growth going forward. The current yield is 7.6% and we anticipate that this will rise over the next year.

The bottom line

The nature of property investment means that it has always been appealing to investors looking for on-going yield, but with some potential upside in terms of capital growth at the end. The issue in the current economic environment is that yields from some property investments are simply not high enough, particularly for investors relying on it to live. In this case, commercial property in general, and unlisted property trusts in particular, are certainly worth considering.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.