Chapter 03 – Commercial property

The roles of property in the financial planning process

In financial planning theory, property, in all its species, was traditionally regarded as a low volatility and hence a low risk asset, with an expected return, therefore, somewhere between the cash rate and the average return on equities.

The introduction of property into a portfolio was thought to reduce risk without having a significant effect on expected rates of return, particularly as past price patterns indicated that property prices and equity prices do not have a high positive price correlation. If equity prices were falling, there was a good chance that property prices were increasing, but there was no guarantee of this.

As often happens, in recent years at least this theory has not been supported by the facts.

In recent years property has emerged as one of the highest earning asset classes. This, together with its low price volatility and general stability has made it a very popular, in fact probably the most popular asset class. Who knows if this will continue in the future?

Most clients own their own home, and therefore have an automatic exposure to residential property. Many have one, two or even more residential rental properties. Usually these have been very good investments. Commercial property is, however, very much a separate asset class and separate exposure to it is generally recommended. This recommendation stands on its own, and is soundly supported by the facts: it does not depend on a risk reduction/diversification argument posited by the traditional theorists.  Commercial property, in its various forms, has generally been a very good investment and will probably continue to be a very good investment.

Property and risk minimisation

Property tends to have much less price volatility than other classes of investment. This means that property has the effect of stabilizing an investment portfolio and hence reducing the risk in it.

What is commercial property?

Commercial property can be defined as any property other than property used for residential purposes. Therefore it includes shopping centres and malls, strip retail stores, farms, tourism assets, offices, factories, some sporting facilities and medical and dental surgeries. By defining commercial property as “any property other than property used for residential purposes” we emphasise purpose over form.

“Commercial property” is therefore a broad term covering a wide range of property types. These types have quite different risk/return characteristics and will follow different trends and cycles, further compounded by geographic factors. For example, it is not unusual for rural land in South Australia to increase in price after a good grain cropping season at the same time that sugar cane plantations in Queensland are dropping in value.

Tourism assets, rural land sporting facilities are generally not owned by clients, and the remainder of this discussion will exclude them and focus on the more familiar offices, factories and shops, ranging from small local facilities to the huge CBD and industrial zone complexes.

Returns from commercial property

Returns from commercial property comprise rents and capital gains (or losses).

Commercial property rents are generally high relative to residential property rents. Capital gains tend to be less than for residential property. Exceptions can occur, as can losses, but generally the capital gain is determined largely by the inflation rate, since this tends to determine rent increases. If a property’s annual rent increases by 3% then, all things being equal, one would expect its value to increase by 3% too. But things are rarely equal, and this will be reflected in the change on yield. As indicated above, value is an inverse function of yield, so falling yields mean higher values and rising yields mean lower values.

Yields are determined by a number of factors, some apply to the general economy, some apply to the property’s location, some apply to the type of property and others apply to the particular property. The factors include:

  1. General economic conditions. Favourable GDP forecasts normally mean that businesses will need space;
  2. Local geographic/demographic conditions. For example, the new ring road in Melbourne has led to higher values in the surrounding suburbs, due to their increased accessibility, and the expansion of a shopping mall will lead to lower values in local retail strip shopping facilities; and
  3. Matters relating to the property itself, including the length of the lease, the timing of rent reviews, whether the lease allows for automatic increases, and the financial strength of the tenant.

An example may help explain how commercial property is valued. Assume that a factory in a high demand area was bought in 2013 for $2,000,000, on an annual rent of $200,000, reflecting a 10% yield. Since then the rent has increased 9%, and is now about $218,000. The local commercial real estate agents say that similar properties are now selling on yields of 8.5%.

The situation is as follows:

  2013 2015
Rent $200,000 $218,000
Yield 10% 8.5%
Value $2,000,000 $2,564,705
Percentage increase in market value 28%
Percentage increase connected to rent increase 9%
Percentage increase connected to change in yield 21%

Why should clients invest directly in commercial property?

Clients should invest in commercial property because it is an asset class that generates high returns with relatively low risk. This risk can be diversified down by investing in a mix of commercial properties, whether by owning multiple properties or by owning indirect property, through listed property trusts, certain managed funds and property syndicates.

Over the last 20 years commercial property returns have averaged more than 10% per annum, and in the last ten years it has been the second highest performing asset class, second only to residential property.

If commercial property comes second to residential property, then why own any commercial property? Why not only own residential property?

One reason is that commercial property usually generates higher income yields than residential property. Rental yields of 7% or more are not unusual, and rental yields of 10% are encountered as well, whereas residential property yields are normally closer to 3% (with occasional exceptions in less popular areas). And with commercial property the tenant pays the outgoings (rates, repairs etc), not the owner, so there are lower cash outgoings as well. Higher yields and lower outgoings mean cash flow positivity even with high levels of gearing. That is more cash comes in than goes out, even before the tax advantages are considered. Many geared commercial properties don’t just cover the interest on the loan but they also cover the principal repayments as well.

This compares very well to residential property, where the cash flow effect is usually negative. One month after the client settles the purchase of a residential investment property, cash flow is down compared to what it was before; whereas one month after the settlement of an industrial property, cash flow is up compared to what it was before.

Each purchase of a residential property reduces the client’s ability to service the loan on the next residential property investment; whereas each purchase of an industrial property increases the client’s ability to service the loan on the next industrial property investment. This of course ignores capital gains: historically residential property has achieved significantly higher capital gains than commercial property. Obviously clients buy residential property with medium and long term capital gains in mind: why else would you borrow at 7% to buy an asset earning 3% rent? The answer has to be an expected capital gain in five, ten and twenty years’ time.

But expected capital gains down the track are pie in the sky if a client cannot meet the loan repayments in the meanwhile. Another reason why clients should consider owning commercial property is diversification. Studies show that diversifying across asset classes reduces risk. It boils down to not putting all your eggs in one basket: if you have all your wealth in one asset class your fortunes are 100% determined by that asset class’s performance.  But diversification is a two edged sword: it reduces up-side risk as well as reducing down-sized risk. Warren Buffet has said something like “put all your eggs in one basket and then take really good care of that basket”. It all depends on the individual client’s risk tolerance profile, and most prefer some diversification.

Commercial property usually has much longer leases than the residential property. Lease terms of five years, with options for a further five or ten years at the end are common. This creates more security than residential property, where terms are usually for no more than a year. Most residential property tenants see themselves as renting short term, whereas a business in a well located retail strip, or a manufacturing plant with specific features, will want to secure their own goodwill by obtaining security of tenure. This means they want the certainty attached to a long term lease.

Diversification from residential property to commercial property makes particular sense when the cash flow positivity of commercial property is considered: this positivity creates a cash flow buffer that takes away some of the stress of residential property prices falling. Often we suggest clients build up a portfolio of two or three residential properties, plus their own home, and then diversify into commercial property. Another residential property may have created too much strain on the practice’s cash flow, whereas a commercial property instead adds to cash flow and alleviates some of the strain caused by the existing residential properties.

Why don’t more clients invest directly in commercial property?

There is a strange reluctance for clients to invest directly in commercial property, at least other than in their own business premises. And if the business premises is a converted residential property it is apt to behave more like residential property than commercial property anyway.

A common reason for not holding commercial property seems to be a lack of information. Most text books barely touch the topic, dedicating a few paragraphs, at most, to the topic, and normally centring on the risks connected to it rather than its benefits. A recent review of the academic training requirements for financial planner’s shows that direct ownership of commercial property is not covered at all, and neither is residential property. These are amazing omissions: the training processes for Australia’s future investment advisers and financial planners omit the two best performing, most commonly owned and highest dollar value asset classes.

When asked if they would consider owning commercial property most clients immediately observe how risky it is and how an owner can easily end up without a tenant. Maybe 5% of commercial property falls into this bracket. For example, experienced valuers have observed that the historical vacancy rate for commercial property in the Moorabbin industrial belt, in Melbourne’s southern suburbs, is less than 4%. This includes a lot of tin sheds that an astute client would not think twice about. It is actually less than the average vacancy rate on residential property. Like residential property, it all depends on which property, and following the mantra “location, location, location” will not take you far wrong.

One valid reason for not owning commercial property relates to the high entry prices. Ten years ago it was not uncommon to see factories valued at $500,000 generating rents of $50,000 per year, or rental yields of 10% per year. These were great buys. Nowadays inflation and price increases, partly driven by a substitution effect out of residential property, mean $2,000,000 is closer to the mark as an entry point for higher yielding properties, and the top yield is likely to be closer to 8% or may be 9%. Not every client can come up with the 30% equity needed to buy such a property, meaning $600,000 of owners’ equity plus $1,400,000 of debt. $600,000 is a pretty high barrier to entry, and bars most people, including most clients, from entry.

Another valid reason for not owing commercial property relates to its lack of liquidity. Commercial property can be hard to sell. It’s a supply and demand thing: there are fewer potential buyers than there are for other asset classes and there is no established “clearing house” as there is for the share market. It is not unusual for there to be a delay of as much as a year from the time the decision is made to put the property on the market, and the ultimate receipt of the purchaser’s cheque.

The high entry prices may be overcome by co-ownership and the lack of liquidity can be overcome by arranging bank debt access facilities, like those routinely available on borrower’s home.

Commercial property also attracts transaction costs such as stamp duty. Work on an average of about 5% for stamp duty, except for Queensland where the top rate is 3.75% (transition rules apply, with lower rates for lower value ranges). Land tax can also be an issue, especially where the land value is high relative to total value (although it is tax deductible, which means it not quite as bad as it may first seem).

An example

A client bought a factory in Moorabbin Victoria for $2,000,000 including stamp duty and other transaction costs. It is leased at $160,000 or 8% yield for the next five years. The tenant pays all outgoings including land tax (on a single holdings basis). The tenant is stable and has operated from the site for more than 20 years.

The bank lent the client 70% of the total cost of the property and the client contributed a further $600,000. The interest rate is 7.0% pa. The term of the loan is ten years.

The maths look like this:

Rent $160,000
Less interest (ie $1,400,000 times 7%) $98,000
Net rents $92,000

The net rent of $92,000 represents a return of about 15% on the client’s $600,000. If an unrealised capital gain arises each year of, say, 3% (ie. about the inflation rate) then this generates a further 10% return, taking the total return on the client’s investment to about 25% pa.

Of this 25% return, 10%, ie the unrealised capital gain, is not taxed, and about 3% is sheltered from tax by large depreciation claims and similar items. This makes the investment very tax effective.

The investment is cash flow positive. This means it generates more cash than it costs to hold it. This excess cash is paid back to the bank, and the debt will be eliminated in about 8 years’ time. In fact the investment is so cash flow positive that it is also repaying all the principal due on the loan.

The big risk is that something will happen to the tenant, or that for some reason the tenant will not renew the lease at the end of the current lease. This means a big part of the due diligence is finding out about the tenant and forming a view of the “lettability” of the property if for any reason it became vacant. A valuer’s report gave comfort here, indicating that historically the Moorabbin area had experienced only a 4% vacancy rates, and the vacant properties tended to be the lower quality older properties. Local real estate agents confirmed this view.

Not all commercial properties behave this way. The more fashionable retail areas sell on much lower yields. Historically these have been as low as 5% to 7%, but recently have fallen as low as 3% to 4%, as clients flee the stock market and fail to realise that retail property is an entirely different beast. A substitution effect from a hot, if not over-heated, residential property market may also be at work here. It’s hard to see how commercial properties bought at these yields will ever perform as investments. These buyers have paid too much.

There are many traps in the commercial property market. There is a risk that an attractive yield will cease when the current lease ends, and the proud owner will be left with an un-leasable, and hence worthless, property. A property is only as good as its tenant and the key to buying commercial real estate is the concept of “future maintainable rent”, ie not the current rent, but the rent that could realistically be achieved if the property was placed on the market tomorrow. This is the rent you should do your sums on.

Negotiating the actual purchase of commercial real estate can also be a treacherous process. It is a good idea to engage someone else to do the evaluation and purchase negotiations for you. It is a tad presumptuous to think that a novice property investor can out-negotiate a seasoned full time real estate agent. Time and time again we have seen the asked for price fall significantly once a professional buyer gets involved.

The Dover Group