Over the course of 2020, commercial property unsurprisingly lost some appeal to investors, as movement restrictions emptied out assets like office towers and shopping centres. But as the dust finally settles, prime commercial property assets have been more resilient than many expected.
Helped by reliable tenants leasing to timeframes longer than the worst Covid-19 predictions, prime CBD office towers have retained their tenants and maintained stable incomes. Some property types, such as the warehouses involved in distributing online goods, have boomed.
With cash going nowhere, stock markets looking volatile and residential markets priced through the roof, experts say commercial buildings now have a strong role to play in de-risking and diversifying investor portfolios in uncertain times.
Australian commercial property investments were performing better than those in most other first world countries prior to the pandemic, says Richard Jenkins, co-founder and director at property and construction consultancy firm Plan1. Growth rates hit record lows during the pandemic, but strong fundamentals will be the driving force as vaccination rates rise and movement restrictions are eased.
“Fundamentally we had a shortage of property across all classes two years ago,” Jenkins says. “Once borders are reopened and the pandemic is mostly under control, population growth will resume at that point, and that will raise demand for property.”
The easiest way for retail investors to access commercial property is through a fund, which offers diversification through a mix of assets across different geographies and tenants.
Steven Bennett, CEO of the Direct Property business within property investment giant Charter Hall, points to a range of benefits to commercial property funds that he says are often overlooked by investors and even some financial planners.
Firstly, a fund from a good manager allows retail investors to access Australia’s most prestigious properties.
“If you want a prime office building in Martin Place, we have that,” Bennett says. “If you want exposure to the booming industrial and logistics sector, you can have it.”
Additionally, Charter Hall’s tenants are typically large corporations or government entities with structured and contractually-bound rent increases.
Charter Hall’s two office funds – its Direct Office Fund and its PFA Fund – have weighted average lease expiry of around eight years. Its diversified fund offers 8.5 years and its industrial fund around 11 years. These portfolios deliver long-term, stable distribution yields of 5.5 to 6 per cent–much higher than residential property, Bennett notes.
And while residential property is known for its tax perks, commercial property has some major tax advantages of its own, Bennett says. Depreciation and amortisation benefits mean investors typically don’t pay tax on 40 to 60 per cent of the investment income, depending on the fund, and also benefit from the capital gains tax discount at the time of selling.
The impact of Covid-19
Movement restrictions since last year have delivered a hit to a number of commercial property sectors, impacting assets that were previously considered safe, such as prime office towers and major shopping centres.
But property has fared better than expectations prior to the pandemic, says Jenkins. Long leases, in particular, have helped smooth out the volatility in comparison to other asset classes like the share market.
“At the moment while office spaces particularly in CBD locations aren’t being occupied, I would say 90 per cent of office space is still leased, even though it is not physically occupied, which protects the values of those assets” Jenkins says.
While the role of the office is changing, perhaps permanently, as more people work from home, few expect the office to ultimately become redundant, Jenkins says. The office plays a central role in collaboration, education and, critically, organisational culture.
More than ever, top employers are going to invest in their office spaces to entice employees to work there, Jenkins says, predicting a “flight to quality” that will favour prime office buildings over lower quality assets. Things like air quality, amenities and a central location will be more important than ever.
And while online shopping continues to deliver a major hit to physical retailers in addition to the impact of the pandemic, the role of physical shops is not dying, but rather shifting towards a greater focus on the consumer experience, Jenkins says. He also argues the increasing prevalence of work-from-home arrangements will bring some of the CBD shopping dollar to high-quality suburban retail strips.
The industrial property sector has been one of the greatest success stories during the pandemic, most notably warehouses involved in the storage and distribution of goods and services purchased online.
Developable industrial land has come under high demand, with land values in Brisbane, Sydney and Melbourne experiencing year-on-year growth of more than 20 per cent over the past two years, according to Plan1. And this demand is compressing yields to record lows across Australia, with average industrial yields in Sydney at 3.75 per cent, Melbourne at 4.25 per cent and Brisbane at 5 per cent.
Online shopping was already booming before the pandemic, but the onset of Covid-19 accelerated this change in consumer behaviour, pushing more hesitant older generations to join their younger peers in buying goods and services online. The online retail spend hit approximately $36 billion in July 2021 or 12 per cent of the total retail spend, up from 6 per cent a year earlier, according to statistics provided by Plan1.
Supply chain issues revealed by the pandemic have also catalysed two key trends that are boosting demand for warehouses, says Bennett: the on-shoring of manufacturing capabilities; and the shift from just-in-time to just-in-case inventory management.
Tips for investing
Among the benefits of commercial property to retail investors, low correlation to bonds and equities are a strong selling point, says Brad Mendel, director at global wealth manager BMF Wealth. Commercial property complements other parts of the portfolio by increasing income and dropping overall portfolio risk, Mendel says.
“Commercial property is a particularly good volatility balance in the portfolio,” Mendel says. “Last year, for example, when the market sold off and equities were crushed, the unlisted parts of the portfolio with property or other investments held its value better. Even if there were some write downs during the year, they were nowhere near the stock markets.”
Low interest rates have helped drive listed Real Estate Investment Trusts (REITs) to trade at premiums to their Net Tangible Asset value, Mendel says, so unlisted commercial property funds offer better value for those entering the sector.
Counter-intuitively, unlisted funds can be more transparent when compared to a giant listed REIT, he says. “Generally with unlisted funds, you have a list of properties they have and you have the opportunity to speak to management a bit more about them compared to listed managers.”
Unlike investing in the stock market, unlisted commercial property should be seen as an illiquid asset to be held longer term, and this can initially deter some investors, Mendel says. But illiquidity isn’t inherently a bad thing for those with a long-term mindset. While the returns aren’t as exciting as a stock like Tesla, they are consistent and a lot less volatile.
“The illiquidity part and the timeframe can turn off some investors initially, but I think it’s needed at the moment to be illiquid to some extent,” Mendel says.
And bear in mind you are putting a lot of trust in the management of a fund, Mendel continues, as funds are typically evolving over time, adding in new properties as they raise new capital. The fund in a few years may be different to how it is now. A good manager with a strong research team will probably make better guesses than an individual investor in terms of which opportunities and sectors show the most promise.
Bennett emphasises that the most important part of investing in a commercial property fund is looking at the manager’s track record, and the quality of the assets.
Says Bennett: “We really encourage people to look through and understand the quality of the assets. Look at what tenants are paying and what the gearing level is. And look at the manager’s track record and whether they have consistently delivered and even outperformed what they said they would do.”