What do higher interest rates mean for your investments?
Investing | 8 minute read
Property is one of the favoured investments of Australians due to its potential to provide both income and capital return. Its low volatility relative to other asset classes, such as equities, is a strong attraction.
Property is an asset class which is usually separated into two distinct groups – residential and commercial.
Residential property, which can include your own home, holiday home or residential investment property, is the most commonly held type of property investment by volume. Commercial properties are generally used for business purposes and are usually divided into four categories: retail, office, industrial and specialty.
The fundamental difference between commercial and residential property is that commercial property investments are generally made on the basis of yield. The value of a commercial property is based on the income return it will provide to an investor, which is known as the capitalisation rate. The value is affected by factors including the lease terms, quality of tenant and other building attributes.
There are a number of ways through which investors can gain exposure to commercial property, ranging from direct investment, private syndicates, pooled professionally-managed property trusts, ASX-listed real estate investment trusts (A-REITs), or unlisted property trusts.
There are several benefits investors gain from investing into a commercial property trust:
Unlisted property trusts provide an investment with characteristics most like a direct purchase of a commercial property, with the added benefit of professional management.
As unlisted property trusts are generally priced based on the underlying valuation of their property assets, their price volatility is a lot lower than A-REITs and the value of the investment is primarily influenced by movements in the commercial property market rather than by the broader share market.
There are two types of unlisted property trusts, open-end property funds and fixed-term, closed-end property trusts (often referred to as syndicates).
Open-end funds don’t have a maturity date or a finite number of units. Instead, they can continue to issue units so long as they raise money, using the new funds to purchase additional properties.
As there is no specific maturity date, to allow investors to exit the investment the fund must have some other method of liquidity. Liquidity is usually provided by holding a portion of the fund’s assets in cash, using new investors’ funds to pay out exiting investors, or selling assets if necessary. This can allow investors to exit at regular intervals.
As with A-REITs, these funds tend to have a number of assets to increase diversification, but it is at the manager’s discretion to buy or sell assets, so investors do not have certainty over the properties they are investing in.
Syndicates contain one or more properties that will be held for a specified period of time, usually five to ten years. At the end of the specified time, investors will vote on the future of the trust, with the default outcome usually that the property be sold, the trust wound up and investors paid out. Syndicates should be considered illiquid investments and you need to have an expectation that you will remain in the investment for the full investment term.
Market volatility has dramatically increased investor interest in simpler syndicate investment vehicles since the GFC. Syndicates provide a strong proxy for the direct purchase of commercial property. They are generally fairly easy to understand and you know for certain which property (or properties) are going to be owned. Therefore, if you don’t like the property, you simply don’t make an investment in that trust.
Single property syndicates don’t provide any diversification on their own, but because the minimum investment is generally as low as $10,000, you can combine investments in a number of syndicates to provide diversification by property, location, sector and manager.
Ideally, you would also choose syndicates with different maturity dates, so you are not reliant on the property market being strong at a given point in time.
A key reason for using an unlisted property trust is gaining the expertise of a property manager. The best property fund managers have an internal property management division which looks after the buildings in the trusts it manages. Having this function in-house ensures buildings are managed properly, and their capital value and appeal to current and prospective tenants is maintained.
Property management includes leasing, ongoing maintenance of buildings, building concierge services, fire safety and other compliance requirements and, most importantly for investors, making sure rent is collected! Investors pay for these services, but they will already be taken into account in the forecast distribution rates in the given trust.
The trust will generally be charged acquisition fees, ongoing management fees, property management fees and various other fees by the manager depending on the individual trust, its assets and structure. The trust is also likely to pay stamp duty for the acquisition of properties plus legal and other costs.
Any returns forecast will take these fees and costs into account. ASIC requires all managers to display their fees and costs in a consistent format in the Product Disclosure Statement (PDS), which makes it easy to compare the fees associated with various unlisted property trusts.
The trust will receive rental payments from tenants and this is passed on, less the aforementioned expenses, to unitholders as distributions on a regular basis. Depending on the trust, distributions may be paid monthly, quarterly or six-monthly.
These are essentially illiquid throughout their term unless you or the fund manager can identify someone to purchase your units. At the end of the trust’s term, the property is sold, the trust wound up and investors paid out proportionately to the units they hold.
Each open-end property fund will have a different liquidity mechanism, but as the underlying property assets are illiquid, the ability to exit the fund will have limitations. Common ways of providing some liquidity is to hold some of the fund’s assets in cash, using cash from incoming investors or, if demand is high and market conditions allow, selling assets.
The manager of an unlisted trust provides you with a lot of information about the trust and its assets in the PDS, so it is important to read and understand it – particularly the ‘Risks’ section. Third-party organisations such as Lonsec and Zenith are also useful, as they provide a detailed review of the trust and its assets.
There are a number of additional aspects of a trust that are worth reviewing. These include the manager, distribution yield, property asset – inclusive of all the considerations within, such as location, building quality, growth, tenants, lease and green credentials – the trust structure, fees, borrowing and more.
For more in-depth information on this topic, download Cromwell’s Essential Guide to Investing in Unlisted Property Trusts at www.cromwell.com.au/essential-guide