The solid returns of unlisted commercial property are often overlooked in SMSF investment discussions to the potential detriment of their members, writes Richard Stacker.
In the sea of words written about retirement savings and SMSFs, one subject slips under the radar and that is property. Not all property, but blue-chip commercial property.
Why is it that so many SMSF trustees and members are overlooking the potential returns of commercial property?
In the current yield-challenged post-global financial crisis (GFC) worldwide environment, where else can you hope to receive around a 7.5 per cent running yield and a forecast 10 per cent total return for a relatively safe and secure investment?
Residential property is unlikely to generate such returns, despite this being the headline grabber over the past 12 months or more.
The dominant themes in this context have, of course, been an explosion of spruikers trying to sell residential property to trustees and prospective trustees, often off the plan and often as a package deal tied to establishing an SMSF.
The tandem theme has seen the risks of excessive borrowing to finance residential property into an SMSF. A range of regulators, including the Reserve Bank of Australia (RBA) and the Australian Securities and Investments Commission, have issued warnings, both official and unofficial, about these risks.
More recently, the focus of debate has shifted beyond SMSFs and residential property to the wider issue relating to residential property values, namely whether or not there is a bubble in the space, with the RBA’s Glenn Stevens and Treasury head John Fraser in one corner and Prime Minister Tony Abbott and Treasurer Joe Hockey in the other.
In this environment, it is little wonder an intelligent public debate on the opportunities for retirement savers in the commercial property market is overlooked.
Portfolio construction
We will begin with some big picture numbers. It’s widely agreed the large superannuation funds and institutional investors generally have a 10 per cent to 20 per cent allocation to commercial property.
By comparison, recent ATO figures show SMSFs have close to a 14 per cent allocation to property that includes a distribution of 3.5 per cent to residential property. The complication here is that these figures are dated, opaque and further detail is guesswork. What we know from extensive anecdotal evidence is that much of the commercial property allocation in SMSFs involves trustees’ own business premises they place in their SMSFs and then lease back under strict guidelines.
What we don’t know is the allocation to high-grade, arm’s-length commercial property, such as high-grade office and industrial buildings.
We do know if related holdings of business premises are stripped out of that 10.5 per cent (14 per cent minus 3.5 per cent), the holdings of first-class commercial property not related to any SMSF trustee or member is a smaller number and probably a small number.
In short, despite the paucity of hard data, there is general agreement a great many SMSFs are underweight high-grade, third-party commercial property.
The yield opportunity
The facts speak for themselves.
Residential property usually struggles to achieve yields of 2 per cent to 3 per cent and that’s often before taking account of initial transaction costs and ongoing holding costs, such as land tax and repairs and capital items to maintain the property.
Listed commercial property or real estate investment trusts (REIT) are currently averaging yields around 5 per cent. Besides the quality of the assets, the attractions here include liquidity as REITs are listed on the ASX. The downsides include returns around one-third less than available from unlisted property and the volatility of REITs generally following the ups and downs of the domestic equities.
With unlisted or direct property trusts, the value of your investment always reflects the value of the underlying asset or assets and is not directly correlated to the volatility of the share market.
Liquidity: the pros and cons
An important issue for many concerning unlisted property trusts is liquidity. Trusts have a nominated life span, generally around five to seven years. The expectation when investing is your funds are invested for that period outside regular liquidity events, which may afford the opportunity for a small quantum of redemptions. The quality of certain funds has seen strong demand for units looking to be sold by existing investors.
Investors should be aware unlisted property is essentially an illiquid asset.
It’s important to note funds for unlisted property investments should come from one’s long-term investment bucket, not the cash or liquid bucket.
In fact, lack of liquidity can have significant advantages. Why?
Consider all those retirement savers who fled to cash immediately after the GFC.
These investors liquidated at precisely the wrong time in the economic cycle and have missed out on large capital appreciation in stocks and property.
With SMSF cash holdings currently sitting at around 30 per cent of total SMSF assets, it’s reasonable to assume much of this cash has never been reinvested and those who fled to cash are still missing out.
Had one held investments that were not easily liquidated, one could have been forced to hold these assets and ride out the cycle and therefore be invested when asset values started to appreciate after the GFC.
The returns from equities and property since the GFC are many times greater than cash.
Another observation about liquidity: there is a level of comfort to be had knowing you have a safe, long-term asset providing a very steady income with no immediate decisions required concerning how and where to reinvest that capital.
A hierarchy of yields
Today, cash, in the form of term deposits, is currently attracting around 2.7 per cent for tying up your money for four years. You may get 3.1 per cent over five years if you are quick, given many believe Glenn Stevens has his hand on the rate reduction trigger yet again.
REITs are generally yielding around 5 per cent and are subject to the volatility of the Australian Securities Exchange, and residential yields are half this number or less.
Further up the yield totem pole are direct or unlisted property funds from managers like Charter Hall offering a potential return of between 7.25 per cent to 7.5 per cent a year and an expectation of a total return when capital appreciation is included of 10 per cent yearly over the life of the investment.
The four signposts
There are four key characteristics to examine when considering direct or unlisted commercial property.
The first consideration should be the quality of the organisation managing the property trust. This translates to track record, brand, transparency, corporate governance, independence and financial strength of the organisation.
A second critical issue is the quality of the tenants occupying the properties making up the trust. Industry speak for this variable is the quality of the covenant. Clearly having a national brand name, such as a Coles or Woolworths, is preferable to a small independent company with little track record or proven financial security.
Third is what’s known as the WALE (weighted average lease expiry) of the properties in the fund. It’s a folly to be attracted by higher than average returns if they are only temporary and the properties could be subject to vacancies within a few years of investing and well before the expiry date of the trust. Thus the longer the WALE, the better. The one qualification here is long WALEs would be a negative in the unlikely situation the properties within the trust are significantly under rented; that is, the rents are below market.
Finally, attention should be paid to the level of gearing within the trust. Gearing is a means of increasing rates of return with the caveat that the higher the gearing, the more risk associated with the trust. At Charter Hall we aim for a gearing level of around 45 per cent, one we believe is prudent. Some property managers have trusts geared as high as 60 per cent to 70 per cent. Should values take a negative turn at a critical time, the debt covenants are likely to be breached, which can result in the equity of investors becoming severely diluted and their capital being put at risk.
The big picture
Spreading risk through the means of a balanced portfolio is one of the basic tenets of investing. With ATO numbers showing SMSFs have a significant bias to cash and Australian equities, there could not be a better time for trustees to consider widening their investment scope and seriously looking at the risk and return equation of direct commercial and industrial property investments.
Recently released research from Folkstone only serves to remind SMSF trustees of the potential value commercial property can add to a retirement portfolio.
It shows non-residential property has delivered a total return of 10.4 per cent a year over the past 15 years, outperforming Australian REITs (5.9 per cent a year), Australian equities (9.1 per cent a year) and bonds (7.7 per cent a year).
Of the property classes, industrial property has been the standout performer over the past three years, generating a total return of 11.2 per cent yearly over the past three years.
Of course, past performance is not necessarily a guide to future returns, but consider the following.
The spread between prime commercial property yields to the cost of debt and fixed interest is the most attractive for a number of years. The money markets are currently predicting a cash rate of 1.8 per cent by the end of this year.
Current average prime property yields represent an income return of 3.6 times that provided by a five-year government bond. This is the highest multiple on record and more than double the 10-year average of 1.8 times.
Next time you drive past a gleaming office building in Sydney or Melbourne or a Coles distribution centre in regional Australia, pause for a moment to think if you wouldn’t mind being an owner rather than an onlooker.