3 ways to get started in commercial property
Investors are increasingly convinced of the real estate story, attracted by a healthy income return and long-term capital growth without the volatility of the sharemarket. But deciding to invest in commercial real estate is the easy bit; deciding how to go about it can be more difficult.
The options available to SMSF investors in real estate are dependent on how much they have to invest, but three of the most accessible are direct ownership, syndicates and open-ended funds.
An enduring appeal of real estate is that it’s tangible and investors often simply like owning something they can see. There are, however, practical limitations to direct ownership that need to be considered. Property is lumpy and for most investors owning commercial property directly would take up a sizeable portion of their funds.
Let’s consider an investor with a total investment portfolio of $1 million. A quick search of a few commercial property websites shows that $1 million doesn’t stretch very far. Many investors with $1 million would rule out direct ownership of commercial property on the basis that it represents a heavy concentration in one asset and requires them to put ‘too many eggs in the one basket’.
Another consideration is that fact that many commercial properties are only large enough for one tenant; without that single tenant the property would be vacant and producing no income. No investor wants an empty property but for some SMSF investors there can also be unfavourable tax consequences if the property isn’t producing enough income.
Furthermore, commercial property requires a great deal of time and expertise to manage even if a property manager is retained. Finding the right property to buy, appointing a leasing agent, considering any environmental issues and legal action are often beyond the remit of the property manager and therefore left to the owner to sort out. As such, investors need to recognise the work that owning a commercial property directly requires. It requires a considerable investment of time as well as money.
Syndicates help overcome some of the issues associated with direct ownership. A syndicate is when a group of investors come together – or are brought together by a professional manager – to buy property and sell it a few years later. By pooling funds together, individual investors can better spread their risk as the minimum commitment for syndicates is commonly as low as $100,000. What’s more, often the syndicate will purchase more than one property in more than one market, which also spreads the risk.
Many syndicates have the added advantage of being professionally managed, which takes the hassle out of commercial property ownership. Of course, this comes at a price. Costs can include the legal and accounting charges incurred to set up the fund, any expenses associated with initially raising money from investors, debt establishment fees, an upfront entry fee to come into the fund, acquisition fees when a property is purchased, fees for managing the assets, fees for selling the properties and a performance fee if fund returns exceed the target. Still, syndicates have been well supported for a long time. Many investors see the value of professional management as out-weighing some additional costs.
Another important feature of syndicates is that they almost invariably use 30-50% debt (also called gearing). This changes the risk profile of the investment. When things go well and returns are strong, they will be even stronger if debt is used. The flip side, however, is that poor returns will also be magnified. The degree of magnification depends on the amount of debt used; that’s to say, the more debt the greater the volatility. If property is being used to reduce volatility within an investor’s portfolio then it makes sense to keep debt to a minimum; for example, less than 30%.
Investors are locked into the syndicate from the time they sign up until the time the properties are sold. The advantage of this structure is that there is no pressure to sell assets during the hold period. The disadvantages are there is a lot of pressure on the manager to buy property in the investment period, which can lead to over-paying for assets, and there is a lot of pressure to sell during the divestment period even if it’s not a good time to sell.
There is also no ability for an investor to withdraw from the scheme if they change their mind or their circumstances change. Transaction costs can tally up for real estate investors and this is also true within syndicates. There is no way to avoid transaction costs altogether although their impact is diluted over time, which is one reason why property is regarded as a long-term investment.
For investors wanting to minimise transaction costs and maximise diversification while maintaining access to their money in a low-debt vehicle, open-ended funds may be a good option. As the name suggests, these funds don’t have a finite life and are able to accumulate their assets over years, indeed decades. This helps them to minimise the impact of transaction costs.
As these types of funds buy assets for the long-term, these costs have long since been expensed and are not paid by new investors. Similarly, as there are no establishment costs, investors don’t pay a buy spread or an entry fee to come into the fund. The ability to accumulate assets during the long-term also gives open-ended funds greater diversification. In today’s market, a large syndicate might have five to six properties with 10 to 20 tenants. Open-ended funds typically hold 10-20 properties directly and might have 100-200 tenants on the rent roll.
For SMSF investors with an account-based pension, a well-diversified income stream is very important. In order to keep their tax-exempt status, these investors are required to annually draw upwards of 4% of their account balance depending on their age1. In this context, diversification by location, property, tenant and lease expiry profile take on an even greater significance.
The scale of open-ended funds also means that they do not need to use much debt. The average level of debt held by syndicates is around 40%, compared to less than 25% for the Wholesale Australian Property Fund, and some open-ended funds hold no debt. The distinguishing feature of open-ended funds is that investors can choose when to invest and when to withdraw their money. To allow this – and for other reasons – most open-ended funds maintain an allocation to listed property securities. This does, however, introduce some share-market volatility to the portfolio.
The good news is that investors have choice. Some funds hold less than 25% property securities; in the middle there are funds which hold a 50/50 mixture of direct property and listed property; and there are also funds that just invest in listed securities, some exclusively in Australia and others focused offshore. These funds are often available to SMSF investors with as little as $10,000.
Commercial property is becoming an increasingly compelling story. But more than any other asset class, deciding to invest is only the beginning. The investment vehicle you choose is likely to play a big part in determining how much risk you’re taking on, what your returns are and whether you can access your money when it’s needed.
About the Author
Christopher is the Fund Manager for the Wholesale Australian Property Fund. Christopher joined AMP Capital in March 2010 as a Portfolio Manager with responsibility for investing a $500m global mandate to invest in unlisted property funds. In September 2010, he became the portfolio manager of AMP Life’s $1.7 billion property portfolio.