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Residential property for living, commercial for investing

Steven Bennett argues the case for confining property investments to the commercial and not the residential sector.

Australians love real estate.

It’s a statement that is hard to argue with, especially when you look at the statistics. According to the Australian Bureau of Statistics, the net worth of Australian households was $9.1 trillion for the quarter ending December 2016. Household residential land and dwellings accounted for $6.1 trillion of that, making it the single largest component of people’s wealth.

I had cause to ponder this issue recently when purchasing a house in an inner-Sydney suburb. Being in the property industry, friends remarked that I must still believe in Sydney residential property as a good investment that is likely to continue its dizzying upward spiral.

My response: “It’s a lifestyle decision. I want the convenience, amenity and stability of living in a pleasant place near work. But I don’t see residential as a good investment at this stage in the cycle.”

There are many reasons I purchased a house to live in, but choose commercial real estate to invest in. For the sake of brevity I can reduce them to four reasons.

First, most analysts and commentators agree the residential real estate market in the east coast capitals is at the peak of the cycle. Banks, with the active encouragement of the federal government and regulators from the Reserve Bank of Australia, are making it more difficult to borrow for residential investment properties because they are fearful of the consequences of a market correction on highly geared investors and the systemic risk such an event could cause.

Second is the extremely low income yield residential real estate displays. With headline returns of less than 3 per cent and often negative annual losses when one takes account of interest rates, taxes (land and transaction) and general costs and interest, residential real estate as a strong income generator has almost become an oxymoron – unless one’s strategy is based on negative gearing.

Third is the lumpy nature of residential real estate. With the new $1.6 million cap on tax-free super nest eggs that came into force on 1 July 2017, for many this will involve a more complex process in recording and accounting for their super fund. The same can be said for the great many SMSFs that hold the members’ business premises as an asset. In comparison, shares and managed funds are inherently flexible due to their small denominations.

Fourth, and critically, are the superior attractions of alternative assets in the property sector and, in particular, unitised investment-grade commercial properties.

Unsurprisingly, as a property professional, I am not suggesting against allocating a certain part of your investment portfolio to property. It’s instructive to observe the professional investors running the large pension funds and sovereign wealth funds globally allocate between 8 per cent and 20 per cent of their investment pool to property.

The interesting point to note is that in Australia these professional investors generally do not allocate any of these funds to residential property. Rather, they allocate funds to investment-grade commercial property, including office buildings, retail centres and industrial distribution centres that form the backbone of an Amazon, Coles or Woolworths logistical operation.

Why do the professional investors avoid residential? It’s a combination of the very low income yields and this class of property being generally a dispersed asset group only – there are not large numbers of residential flat buildings under one title as there are in the United States.

Further, the terms of leases in commercial property are generally linked to inflation or an annual increment of around 3.5 per cent and the quality of the businesses that lease the properties is strong, with a high reputation and a proven commercial track record. Values in unlisted property funds are stable and predictable and reflect the underlying asset value, which is recorded daily or monthly.

The above is a long way of saying, outside of my somewhat leveraged new house, I invest my retirement savings in a range of assets including cash, shares and unlisted property funds and I am not tempted to direct savings to residential property at this point in the cycle.

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