Commercial Real Estate Investments
There are 2 primary means for investors to gain access to real estate exposure in their portfolio. First is through the property trusts listed on ASX (or AREITs) and secondly by owning real estate directly. Commercial property is a key subset asset class within the broader real estate asset class.
The size of the commercial property means investors rarely own them by it self. Rather retail investors gain exposure to commercial assets through either unlisted syndicate trusts or listed property trusts. AREITs can be attractive for investors that are looking for a hands off passive investment or does not have direct property operating experience. The benefit of a listed property trust as mentioned above is liquidity and portfolio diversification across multiple assets, geographies and tenants.
In contrast, directly owning real estate can be attractive for those looking for a hands on approach which leverages on their commercial experience. The trade off are it will be primarily focused on smaller single or double storey buildings where there is tenant concentration risk. The value of the asset would also be a large portion of the investor portfolio unless they are extremely high net worth.
Why invest in Commercial Real Estate?
There are several advantages that commercial real estate can provide verses residential property investments.
The lease terms on commercial real estate assets are typical longer than residential leases. It is common to have 3, 5 or even 10 year lease term for office and warehouses. Retail leases are also typically minimum 5 years compared to 12 month lettings in residential properties.
Depending on the market, the tenant could also pay for all outgoings which covers the operating costs of the building. Example of outgoing costs include statutory rates, electricity, body corporate (strata fees), cleaning and building repair and maintenance. The landlord will be responsible for major building capital expenditures.
Also there can be more flexibility in lease negotiations between the tenant and landlord conditional on the fundamentals of the local markets. Unlike residential leases where there are legislative restraints due to difference in power between landlord and tenants. Almost all points in commercial leases are up for negotiation with the exception being retail leases where each state has its own retail leasing act dealing with the broad terms of the retail leases.
As with anything, there is no such thing as a free lunch. If the landlord or tenant require a specific clause such as right to hand back the property or demolition clauses, there will be associated costs or higher or lower rent. But it is attractive for some to have this flexibility which does not exist in residential leasing.
Types of Commercial Real Estate Properties
Below are the main asset classes within the sector where there is greatest investment demand and liquidity. These are the first port of call for investors looking for commercial real estate exposure in the portfolio.
Office – Commercial office is the most common type of assets associated with commercial real estate. These can either be leased to a single tenant or multiple tenants and typical office buildings are be worth hundreds of millions dollars.
Retail – Shopping Centers are large Retail Commercial Properties. These would have a department store, major discount retailer and super markets. For example the biggest retail landlord in Australia is Westfield. Smaller retail assets are called Neighborhood Shopping Centers which are anchored by a major supermarket, an example of this is Charter Hall Retail. The income profile of retail assets can be quite different to office due to the lease structure where there is typically an Anchor tenant such as department store like Myer or David Jones and Super market such as Woolworths and Coles which pays very little rent relative to the specialty stores. Their rent is low because they provide the critical foot traffic for the centers.
Industrial – Warehouses, Logistic centers and light industrial factories fall within this category. Usually these are single tenant buildings which require a portfolio to get scale to minimize the tenant credit and lease expiry risk. The advantage of industrial assets over office and retail is that lease terms are usually longer.
There are also a range of specialist asset classes which falls outside of the above. These assets are more illiquid and less natural demand from investors. The current strong market enivornment and the chase for yield means that more and more investors are extending their commercial property mandate to include assets in the categories below:
Hospitality – Hotels and Pubs fall into this category. Hospitality is tricky asset class because hotels leases are more complicated compared to other commercial property leases where rent and annual growth is fixed. Hotel leases also include a portion of income dependent on the operational performance of the hotel. Hence hotels are typically sold as operating company which manage the asset and as well as the asset it self. On the other end of the scale, ASX listed hotel management company Mantra group for example is just a management company of hotels. Only a portion of its balance sheet is made up of hotel assets.
Pubs also fall into the hospitality category where there is an operating business along with the commercial building. The issue with taking on the operational risk is that the return of the assets would also be a function of the broader economy which can be uncertain. This is in contrast to standard asset classes where the leases are contracts and returns are known to a degree into the future.
Service Stations – Recently listed Viva is an example of this but alternatively there are not alot of option. The advantage of service stations is its long leases which provides income security. However in our Viva Energy REIT write up we have outlined the key risks associated with service stations.
Childcare Centers – Buildings leased to child care operators. The buildings required for child care are not specialized use buildings but the key risk for these assets is there is low entry barriers for new child care centers so the value of the asset is largely based on the signed lease.
Data Centers – Highly specialized asset class and due to its specialized use, there is significant key tenant and obsolescence risk. One question is what are the alternative uses if the tenant moves out.
Student Housing – Relatively new asset class. One issue investors in student housing need to be aware of is the key substitute for the product is residential housing. There is demand for student housing in strong residential markets but in weak markets owners of student housing is competing directly with residential housing investors for the tenants.
Medical Centers – These could include long term generic properties leased to GP, dentists or specialist to hospitals. Due to the nature of the market it is very hard to find these assets as most doctors are owner occupiers of their own practices. There is a trend away from this but it is slow and options are currently limited.
Commercial Property Grades
Aside from the above asset classes, commercial buildings in each category also fall into various asset grades:
Premium Grade Asset – These are the best assets in each category and demand the highest rents. Characteristics of premium grade include central CBD locations with spectacular views. Examples of premium grade commercial office are Governor Philip Tower in Sydney, 101 Collins Street in Brisbane and Waterfront Place in Brisbane. Example of premium grade retail center is the Sydney City Westfield.
A Grade Asset – Strong and functional buildings that are relative new, energy efficient and close to key transport networks. Ideal for tenants that want a good building in a good location but not necessarily all the best amenities and views.
B Grade Asset – Older style buildings. Although it can still command strong rents due to location but usually is the cheapest option for tenants due to its fringe or suburban locations or older style building quality.
Commercial Real Estate Investment Strategies and Return
It is rare to see negative gearing in commercial property since income makeup a large portion of the total return. Financing are also strict where loan to value is around 50%. In contrast our analysis of long term Sydney house price gains on other hand make up the majority of returns in residential investment.
Commercial assets provides immediate income (largely rental return) with a lower long term capital return profile. That is not to say that commercial assets are lower return asset class. The total return on investment is dependent and leveraged to broader economic backdrop and local supply and demand than typical residential assets. The returns profile of commercial assets also varies depending on the investment strategy implemented.
For example the Perth property market have declined on the back of the Western Australia economy is slowing down following the end of the mining boom. Commercial assets have done worse. But during the boom, the asset class outshines residential due to limited supply.
Summary of the key investment strategies are:
Core – Core real estate strategy is an income based strategy where the fund assets are largely focused on fully leased buildings that are the best in its class and perceived to the safest cash flow. This include mostly premium and A grade assets due to its location and modern construction. The assets would have minor leasing risk as the current tenants has signed long leases and due to the nature of the buildings and the prime locations there is low re-leasing risk. Current owners of major core assets in Australia rarely put them up for sale as the cash flow profile is relatively steady. These are the most sought after buildings whenever they come to the market and are priced accordingly.
Core Plus – Core plus strategy is an add on to the core strategy in which the assets might be considered core are priced at a slight discount. This could be due to the fact that the building could currently have a large vacancy, upcoming leasing risk for the major tenants or major capital works program to bring the amenities up to its peers. Hence investors would require a higher level of return in implementing strategy. Once completed the fund could hold on to the asset or resell as market core prices. The important distinction to these strategies below is that the underlying assets bought and sold are core Premium and A grade assets.
Core funds could have an allocation to core and core plus strategy as part of the overall portfolio management strategy.
Value Add – Value add involves taking on minor development, building reposition and leasing vacancy risk. Whilst investment return of core assets are primarily income driven, value add can be considered primarily capital gain driven. This is because either the assets do not have immediate cashflow because they are vacant or the cash flow is used for capital expenditure to improve the asset. Majority of the return is realized from selling the asset after the value has been added to the building.
Opportunistic – Opportunistic real estate strategy is the highest risk and return profile of all the strategies. Opportunities usually involve funding developments, or taking on development risk from empty land to a fully built office building to achieve the targeted return. This also include buying in markets with high vacancy such as Perth and Brisbane and ride the market to its long term average. Investors should demand the highest return for funds with opportunistic strategy since these the risk is also the highest.