The property market is perhaps the most closely followed sector of the economy, as it drives so much of our economic growth. Drive past any new residential development and count the number of different trades needed to get a house up and complete. And don’t forget the materials.
All of this money funnels its way through the economy, making it tick along. But while new housing starts will top 200,000 this year, it only represents one small part of the property market.
For those looking to invest in property, the residential market is often where they start. Perhaps it’s familiarity — if you’ve bought a home of your own, you’ve got an idea of what’s involved. And it’s something very tangible. You can see and understand what you’ve bought.
It’s a process that has worked well for decades, with appreciating house values, spurred along by the tax incentives of negative gearing. But if you took either of these factors aside, what would you be left with? Something that might give you 2–3% yields after you take out all your costs.
You’re also going to be stumping up a lot of cash to get any deal off the ground, with banks now using stricter loan-to-value ratios (LVR). The LVR is the size of the loan as a percentage of the value of the property.
For many, investing in residential real estate has worked well, but it’s not the only way to invest. One sector that often gets overlooked is the commercial side of the market.
The commercial market comprises things like office blocks, shopping centres, warehouses and industrial estates. It includes hospitals, medical suites and supermarkets — basically any part of the market that rents out a property to a commercial enterprise.
If you’ve got the know-how, and the resources, you could invest in any of these directly. But, like anything else, you’ve got to know what you’re doing. Like a residential property, the lessee can damage the property or be a slow payer. The tenant could also go broke, leaving a highly-leveraged landlord in the lurch.
The property could also sit idle while you’re looking for the next tenant. And if there’s a lull in the market, you could find yourself being undercut by another landlord desperate to get their property rented out.
Another way to invest in property is through the myriad of Real Estate Investment Trusts (REITs) listed on the ASX. Some are strictly small cap, with assets less than $500 million. Others are large cap, owning and operating properties valued in the billions. Take Westfield Corporation [ASX:WFD], for example, with a market cap of $22 billion.
For investors who don’t have the resources (financial or other), or the specialist knowledge required to invest in commercial property directly, REITs can be a great way to get involved.
For a start, you can invest as little (or as much) as you wish. And you can spread your investment around a handful of REITs, giving you exposure to a range of commercial investments. If you change your mind and want to exit the market, you can close out your holding as you would any other share on the market.
In a low interest rate environment, many investors have been attracted to REITs due to their high yield. Large cap REITs like Vicinity Centres [ASX:VCX] — who own and/or operate over 100 shopping malls and properties across Australia — trades on a yield of 5.1%, even after their recent run up in price.
Small specialty REITs like Hotel Property Investments [ASX:HPI] — a small cap that invests primarily in pubs and clubs in Queensland — trades on a current yield of 6.3%. While that might be a great return, it is also perhaps more vulnerable to any regulatory changes in that region or industry.
One of the advantages of REITs is that it is usually easier to quantify yields than it might be with a residential property. While a residential tenant could rent a house for a number of years, the lease period might be only for a period of 12 months. But what happens after that?
You might look to increase the rent, but the tenant moves along. Normally with commercial properties, though, tenants will look for longer term leases. As with the case of the abovementioned HPI, some of their leases run upwards of 20 years.
And for HPI, all have agreed annual rental increases as part of the lease agreements — a much more identifiable and secure yield calculation than you might get on a residential property.
I want to stress, though, that this is not an argument against residential property. It’s to show that there’s more than one way to get involved in the property market. Especially if you don’t have a lot of resources.
While yield is an attraction of commercial property, it is also tied in with value. There’s a relationship between the two — properly maintained and managed properties should increase in value as yields increase on the underlying properties. So REITs are a combination of the two — both yield and value.
But it’s not a one-way street. Commercial properties are still subject to the economic cycle, as is any other investment. Yields can drop along with the value of the property. So you need to look at the portfolio of a REIT before deciding to invest.
One key description I read about from a fund that invests solely in REITs is what they referred to as ‘property being a form of infrastructure’. Is, for example, a shopping centre — like Chadstone in Melbourne — an irreplaceable part of the local infrastructure, or is it just another shopping strip on the outskirts of town?
REITs can be a great way to invest in property without all the hassle of being the landlord. And you can invest in a swag of properties without having to tie up a lot of funds. Just be aware of the risks. An uptick in interest rates, or a slowdown in the economy, can also impact their value.
Editor, Total Income
Ed Note: This article was first published in Markets and Money.
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