Greg Paramor: Opportunities in Non-residential Real Estate

Notwithstanding, Australia is in better shape than most developed economies, investor confidence remains fragile. As a result, it is a challenging time for investors to be putting money to work. Having said that, we believe now is a good time for investors especially self managed super funds to selectively start looking at both non-residential and residential real estate.

One bright spot on the investment landscape is non-residential real estate. According to the PCA/IPD Investment Performance Index, non-residential real estate generated a total return of 10.5% in the year to December 2011, consisting of a 7.5% income return and a 3.0% capital return. Hotels (17.8%) followed by office (10.4%) were the two best performing sectors, with retail and industrial recording total returns of 10.0% and 9.9% respectively. Over the coming year, we expect commercial property to deliver a total return of around 10.0% with an income return of around 7.75% which compared to cash at 3.75% is a reasonably attractive return.

Investors looking for income orientated investments should focus on core assets in good locations with strong tenant covenants, solid cashflows and low leverage ie no more than 50%. In times of economic uncertainty and volatile investment markets, investors are more focused on income than capital growth. There are still however, some investors with a larger risk appetite that may wish to consider value-add and opportunistic strategies such as acquiring non-core secondary assets and repositioning them through refurbishment, providing mezzanine or preferred equity to capital constrained developers and investors, or undertaking developments in selected markets.

We believe the office sector contains some interesting opportunities. The Perth market, and to a lesser extent Brisbane, have run ahead of fundamentals driven by the demand for office space from the resource sector. Low levels of supply continue to be a feature of most markets as new projects require substantial pre commitments to obtain financing and construction. Our preference is for Sydney and Melbourne, and in particular, selected suburban office markets in Sydney. From an investor’s point of view, the yields on suburban office property are typically higher whilst from a tenant’s perspective, rents are affordable and accessibility is generally better.

The retail sector is facing a number of headwinds from both structural (competition from internet) and cyclical (consumers not spending) factors. As a result, we prefer the smaller retail centres anchored by a Coles or Woolworths in good catchment areas that are focused on non-discretionary spending. The major centres will continue to offer customers more than just a shopping experience. The sub-sector most at threat is sub-regional centres – they typically have a higher exposure to discretionary spending than neighbourhood centres without the non-retail attractions of entertainment and leisure that are found in the major regional centres.

One way small investors may wish to access non-residential real estate is via unlisted funds. Unlisted funds pre-GFC were a popular way for investors to access non-residential real estate. However, with the on-set of the GFC, a number of investors got burned due to some funds having opaque structures, high leverage, payout ratios that were unsustainable and in some cases, poor corporate governance.

Our recent discussions with numerous investors and their advisers has detected a growing interest again in unlisted funds. However, they want a new generation of real estate funds that offer:

• simpler, more transparent structures;

• lower levels and better management of leverage;

• a focus on sustainable income;

• clear and concise communication with investors;

• fee structures than align the interests of the investor and manager; and

• exemplary corporate governance.

In response to the growing demand from investors wishing to seek secure income and higher yields, especially now that the cash rate has been lowered to 3.75%, we plan to launch in the next month the first in a series of real estate income funds. The Fund will acquire a brand new Sydney suburban office building leased for 10 years to an international tenant. The Fund will offer investors a forecast first year distribution yield of 7.75% which will be 100% tax deferred.

Investors wanting liquidity may wish to consider the listed A-REIT sector. A-REITs continue to offer good returns, however volatility has been a feature of the listed market since the onset of the GFC. If investors are prepared to take on higher volatility than investing directly in real estate assets or unlisted funds, there are some good A-REITs trading at significant discounts to net tangible assets (NTA). According to Morgan Stanley, the sector (as at May 3) was trading at a discount to NTA of 11.6% with a wide range across the major A-REITs. For example, the Goodman Group is trading at a 46.4% premium to NTA while Australand and Mirvac are trading at 18.8% and 19.3% discounts to NTA respectively.

Despite the reduced payout ratio in the A-REIT sector (currently 80%), A-REITs are offering an average distribution yield of 6.1%, which is a 235 basis points premium to the cash rate and a 268 basis point premium to the 10 year bond yield. However, the range of yields across the A- REIT sector remains quite wide – Westfield is on a 5.3% distribution yield while Charter Hall Retail REIT offers an 8.1% distribution yield.

On the residential front, the recent 50 basis point cut in the cash rate (of which between 30 to 40 basis points has been passed on by the major banks) provided a welcome but somewhat belated stimulus to the market. Unfortunately, it is not the pancrea. The ongoing uncertainty around the economic and domestic political outlook means it will take more than the recent 50 basis point cut to kick-start a major uptick in the residential sector.

According to RP Data, residential values were down across five of the eight capital cities over the month of April, with Hobart (-2.9%), Melbourne (-1.7%) and Brisbane (-1.3%) recording the largest falls. On a 12 month basis capital city dwelling values fell on average by 4.5% with the weakest markets in Melbourne (-7.0%) and Brisbane (-6.4%). It is worth pointing out that not all markets behave in the same manner. According to RP Data, the premium residential market has been hit the hardest. The most expensive 20% of suburbs across the capital cities have seen dwelling values fall by 5.7% over the past twelve months whilst the most affordable 20% of suburbs have seen values fall by 2.3%. RP Data point out that this trend is most evident across the Sydney, Melbourne and Perth markets.

Investors are likely to return, albeit in more measured way, to the residential market over the next 12 months, as an ongoing shortage of rental accommodation and low levels of new supply puts upward pressure on rents. The gross yield on well located, quality residential real estate is now well above 4% for houses and close to 5% for units. According to SQM Research, the rental market is excessively tight with vacancy rates ranging from a low of 0.5% in Brisbane to a high of 2.9% in Melbourne.

Like all investment opportunities, investors need to be cautious, undertake extensive due diligence and understand the risks and rewards. In a low inflation, low growth environment that we are likely to be in for some time, poor buying decisions are not going to be rescued by rising markets.