Investors troubled by the lousy prospects for residential property in most states – with low rental yields and zero-to-little capital gains – are turning increasingly to non-residential property as possible replacement investments. By MICHAEL LAURENCE.

 By Michael Laurence

Investment returns from non-residential property – including small offices, shops and warehouses, commercial property syndicates’ portfolios, unlisted property trusts and listed property trusts – have delivered spectacular returns in recent years.

And solid returns are expected to continue – albeit with greater volatility and less potential for the star-performing listed property trust sector, which has recently had a rough ride on the sharemarket.

As shown in the table below from Mercer Investment Consulting, listed property trusts returned 33.5% in the 12 months to February – eclipsing the much-heralded Australian equity return of 23.6%  – and 25.4% over three years. And unlisted and directly held property returned 18.8% in the 12 months to February and 14.8% over three years.

One of the most positive aspects for non-residential property is that the availability of space is tight – particularly in such cities as Perth – and commercial rents are continuing to rise. The logic is crystal clear: commercial tenants who are having difficulty finding business premises simply have to pay more rent.

The next wave of investors in non-residential property come from self-managed superannuation funds. Numerous members of self-managed funds are reportedly selling residential property held in their own names to make huge super contributions.

Their motive is to take advantage of the transitional measure for the new super system of allowing members to make after-tax contributions of up to $1 million between May 10 last year and June 30 this year. (From July 1, annual after-tax contributions will be capped an indexed $150,000 or $450,000 every three years.)

In turn, many investors who personally sell residential property – typically making high capital gains after the long-running hot residential property market – are likely to arrange for their self-managed funds to directly own small offices, shops or warehouses as a means to gain exposure to the property sector. (Many members of self-managed funds would be comfortable with the ownership of investment properties.) Alternatively, their self-managed funds may decide to invest in listed or unlisted property trusts.

Powerful arguments can be presented for self-managed funds, depending on their circumstances, to directly own commercial real estate – particularly when it accommodates the fund members’ own businesses. (Superannuation law allows a DIY fund to rent business real estate in its ownership to the businesses of members – for a commercial rent, of course.)

Shane Oliver, head of investment strategy and chief economist of AMP Capital Investors, is positive about the overall prospects for non-residential property. He says the medium-term outlook for listed property trusts – over five years – is sound despite the sharp rises in their prices. And his outlook for unlisted property trusts and directly held non-residential property is particularly positive.

Oliver points out that the key investment attributes of non-residential property are:

• Vacancy rates are low and still falling, leading to higher rental returns.
• The bulk of their returns from non-residential property, particularly unlisted properties, are from rent – making them similar to bonds. This reliance on yield means investors generally regard listed property trusts among the sharemarket’s defensive sectors.

Listed property trusts

Oliver warns investors in listed property trusts to expect continued volatility over the short-term. This is because of the rising overall rising volatility in the sharemarket and because Australian listed property trusts are trading at a significant premium to the value of the buildings in their portfolios. “And they are trading at a higher price-to-earning multiple than Australian industrial shares when they normally trade at a discount.”

Listed property trusts fell 9.5% during recent correction against 6.5% for broad market. “The greater fall of listed trusts reflects their greater gain over the last year,” Oliver says.

The yield on listed property trusts has also fallen as their prices have risen. “Their yield had actually fallen last November to just below the bond yield,” Oliver notes. “It’s true that they are less defensive than they used to be – but they still have a relatively high income or yield component in their returns.”

Oliver says a higher level of gearing by listed property trusts had raised concern that this factor alone would increase their volatility. He has seen no evidence to support these concerns.

Unlisted property – including directly held properties

“I think investors are better off in unlisted property trusts and directly held properties than in listed property trusts,” Oliver says. This is because their prices are still catching up to reflect the size of their rental returns. And significantly, unlisted and directly held properties are not, of course, exposed to market volatility.

Oliver believes that it can make much sense for investors, including self-managed super funds, to own, say, a small shop, warehouse or office. He emphasises that the same characteristics that are attractive for investors in trusts that own city office towers, of low vacancy rates and rising rents, apply to investors owning, say, a strata office suite that may be leased to a small accountancy firm or some other tenant.

Self-managed fund trustees should be aware that as with any directly held investment properties, transaction costs for buying and selling non-residential properties can be high. And these properties can take time to sell, which may be a significant factor when a fund wants to pay super benefits to a retiring member.

Source: Mercer Investment Consulting