Faltering residential prices turn spotlight on commercial property funds

By Steven Bennett, Head of Charter Hall Direct

Many investors have made a great deal of money from investing in Australian residential real estate over the past few years. Principally, returns have been via capital gains. Residential property is rarely an attractive income play and indeed frequently involves a negative gearing strategy.

Holding costs are high, and include: land tax, council and water rates, insurance, property agent fees, maintenance and strata fees.  And of course there’s interest.

Entry and exit fees are also high: stamp duty and legal fees going in; agent fees, advertising and legal fees on the way out. Consequently, the headline gains often the subject of dinner party discussion are generally much greater than the real bottom line.

Significantly for residential property investors, the long anticipated price correction appears to have arrived.

Property analyst Tim Lawless of CoreLogic RP Data has called August 2017 as the peak on Sydney residential property prices and notes Sydney property prices are now 2.2% below that peak.  Sydney ‘all dwellings’ prices are down 3.7% for the year with houses down 5.5% and apartments down 0.57%. So much for the often repeated comment that you can’t lose money on residential property.

CoreLogic notes nationally, the ‘5-capital city aggregate’ for all dwellings was down 0.42% over the last year. Looking forward, CoreLogic expects Sydney prices to fall by 5 to 10% over the next 12-24 months. BIS Oxford Economics is predicting Sydney prices to slide between 3% and 10% in 2018, while AMP economist Shane Oliver is tipping a 5% decline in 2018.

There can be no doubt the macro prudential regulations introduced by APRA are beginning to bite. Banks have dramatically tightened their lending practices and are reigning in interest only loans, which are now limited to 30% of the banks total residential lending book.

On top of this is the huge volume of interest only loans due to convert to principal and interest (P&I). The Reserve Bank estimates $100 billion of interest only loans are due to transfer to P&I every year for the next three years. The bank estimates  the average loan payments of borrowers will increase by $7,000 a year as borrowers transition to P & I, putting increased pressure on household budgets and downward pressure on prices.

This new lending environment and price outlook brings into sharp focus the opportunities presented by Australian investment grade commercial property.

It’s important to note that commercial property returns are not correlated to housing prices but to economic activity/growth and population growth. On both scores Australia ranks highly.

This asset class can be easily accessed via managed funds, where the choice is either Australian Real Estate Trust (AREITs) listed on the ASX and/or direct property funds, also known as unlisted property funds. AREITs prices usually follow the movements in the share index. Values increase when the market is up and rates of return consequently reduce. The opposite is the case when the market goes down. With direct property funds, values are listed by the manager daily or monthly and reflect the underlying value of the properties in the fund. Distributions or payments to investors are predictable and relatively steady if managed by a leading property manager. Income returns of 5% to 7%, or more are currently on offer and are usually tax advantaged due to depreciation and amortization.

A prospective investor recently asked why we at Charter Hall are quoting income returns of around 5.8% for our flagship Direct Office Fund while other managers can be quoting prospective returns of up to 7%, or even more for their managed fund.

The short answer is one needs to compare apples with apples.

I point out to prospective investor that our funds have the highest WALE in our class – i.e. the longest weighted average leave expiry in the industry. It means all our funds are comprised of properties with very long leases, averaging around 8+years. This provides security of income to investors.

Equally relevant, Charter Hall targets  first class tenants in the properties we mange. Our tenants are often national brands, or major businesses with outstanding track records, respected institutions or government departments or agencies. A further reason why our funds are seen as class leading, or blue chip, is the quality of the buildings and their strategic location, usually capital cities, and often CBDs.

By the end of our conversation the Charter Hall Direct Office Fund offer of around 5.8% p.a. income distributions - with a total return projection over the period of the fund of around 9% pa when capital growth is factored in at the end of the term - was deemed not only attractive but compelling by this prospective investor.

It always pays to look beyond the headline rate and examine details of the underlying assets.

To find out more, contact us directly or your financial adviser.