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Too often SMSF property allocations focus on residential investment but Nick Kelly argues that greater consideration should be given to commercial property.

Spreading risk through the means of a balanced portfolio is a basic tenet of investing. However, one investment asset class often slips under the radar for SMSFs – commercial property.

In this yield-challenged, post-Brexit global environment many SMSF members are missing out on the potential returns.

This investment class still offers around 6 per cent to 7 per cent running yield, and an 8 per cent to 10 per cent total return for a relatively safe and secure investment.

Compare this with SMSF investments in residential property, where there has been an explosion of spruikers flogging such property to trustees and prospective trustees, often off the plan and often as a package deal tied to establishing an SMSF.

A number of regulators, including the Reserve Bank of Australia and the Australian Securities and Investments Commission, have expressed concern and issued warnings, official and unofficial, about these risks.

The Australian banks’ tightening of lending to the residential sector from foreign buyers is another headwind for SMSF investors targeting the residential sector.

In this environment, it’s little wonder commercial property opportunities are sometimes overlooked.

It’s widely agreed the large superannuation funds and institutional investors generally have a 10 per cent to 15 per cent allocation to commercial property. But many SMSFs are very underweight the professionally managed commercial real estate funds and real estate investment trusts (REIT) that own Australia’s highest-quality real estate.

Recent ATO figures show that SMSFs have an approximate 12 per cent allocation to property, which includes around 3.9 per cent to residential property.

But much of the commercial property allocation in SMSFs stems from trustees owning their own business premises, rather than commercial property such as A-grade office and industrial buildings.

Let’s look at various property investment options and yields.

Home is where the heart can go astray

Residential property usually struggles to achieve a gross average income yield of 4 per cent. Today the average gross income yield on a composite of Australian capital cities for detached homes is 3.3 per cent. That yield is before you take into account landlord expenses such as council and water rates, building and landlord insurance, and the major expense of land tax.

If you buy an apartment, you will have a lower land tax bill, but the body corporate strata fees add even more expenses. In some apartment buildings the body corporate expenses chew up 20 per cent of the rental income, before all the other expenses that need to be taken into account. And these exclude maintenance of the unit or common property, and structural issues that can occur in large apartment complexes.

All in all, residential property has performed very well over the past 10 years, but investors allocating new capital need to ask: what will be the return on my capital if the price I pay today is exactly what the property is worth in five years?

The answer is something like 2 per cent a year – the return will be the net cash the property has generated. And if you decide to sell, after stamp duty and agent expenses, the equity you’ve invested may disappear depending on how much debt you’ve used to acquire the property.

Flexible v volatile: the REIT effect

Listed REITs are a very efficient means for SMSF investors to gain immediate exposure to some of Australia’s highest-quality real estate and, in addition, they are liquid, like any other security listed on the Australian Securities Exchange (ASX). You can invest on Monday, change your mind, and sell on Tuesday.

There’s a lot to be said for this flexibility. However, this does create volatility and listed REIT prices can move around dramatically when global events or large shifts in bond market pricing influence their value.

Some SMSF investors in the current market for listed REITs will note income return on offer is sitting at 4.6 per cent for the S&P/ASX 200 Australian or AREIT Index, based on current broker forecasts. That’s a lot higher than a net 2 per cent income return on residential property.

Unlisted should not mean unloved

Unlisted property funds that focus on commercial property assets are another good alternative for SMSF investors. Certain managers are investing in institutional-grade office, industrial and retail property assets, and establishing funds with high-quality tenants and long leases that provide secure income profiles for investors.

Income yields on unlisted property funds range from 6 per cent to 8 per cent, with lower-end income returns being the lower-risk options with longer leases and lower debt, and other products with income returns at 8 per cent or higher subject to higher risk with shorter leases and higher debt.

Unlisted property funds are illiquid, but an advantage are they are managed with scheduled investment terms. This provides certainty for all investors, who are part-owners of the buildings.

Investors can budget for how long the investment will produce earnings and plan for the realisation of their investment, as the fund termination date and sale of its assets is known.

This provides a far lower level of volatility in the investment, with the asset continually assessed independently at the asset’s property value, and left unaffected by market sentiment on global events, unlike listed stocks.

Importantly though, as an illiquid asset unlisted property should use funds from your ‘long-term investment bucket’, not the ‘cash bucket’.

Unlisted property trusts have a nominated lifespan – generally around five to seven years. Funds are invested for that period, and outside regular liquidity events they may afford the opportunity for a small quantum of redemptions.

There is a level of comfort knowing you have a safe, long-term asset performing well with no immediate decisions required on how and where to reinvest that capital.

Do the numbers before you decide

The current spread between prime commercial property yields and the cost of debt and fixed interest is the most attractive it has been for a number of years. The money markets are predicting a cash rate of 1.8 per cent by the end of this year.

Current average prime property yields represent an income return of over three times what a five-year government bond delivers. This is the highest multiple on record and more than double the 10-year average of 1.8 times.
There are four key characteristics to consider in selecting direct or unlisted commercial property.

The first should be the quality of the organisation managing the trust – its track record, brand and financial strength.

Second is the quality of the tenants of the properties that make up the trust – the quality of the ‘covenant’. Having a national brand name, such as a Coles or Woolworths, is far preferable to a small, independent company with minimal track record or proven financial security.

Third is the weighted average lease expiry or WALE of the properties in the trust. It’s a folly to be attracted by higher than average returns if they are only temporary and the properties could be vacant within a few years and well before the expiry date of the trust. So, the longer the WALE the better.

Finally, check the level of gearing in the trust. Gearing is a means of increasing rates of return, with the caveat that the higher the gearing, the more risk associated with the trust.

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