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Current risks in residential investment property – a time to consider commercial?

Recently there has been a lot of chatter about an expected glut of apartments. This is not surprising given the high level of approvals and construction that we have seen of late.

The basic premise is that the unit market will be over supplied, leading to a shortage of tenants, a drop in rental rates and thus a reduction in return on apartments. In turn this will lead to a drop in their investment value.

Once the drop in value has been identified, valuations for new apartment completions that were sold off the plan will drop, resulting in default in property settlements.

This scenario is not unprecedented, in fact it is a well-trodden path at the top of the cycle.

The above chart from RCLCO in the USA isillustrative of the apartment cycle, which is expected to be mirrored inAustralia.

The simple fact is that the unit market is, by its nature, cyclical.

Of course, there are underlying factors which dictate the long term trends within the housing market:

• population growth

• building costs

• land supply and cost.

These are but a few of the ever present factors within the market.

However, cyclical factors also have a significant role to play. These include:

• general economic cycles within the economy

• the impact of unusual demand from foreign buyers (as we have seen recently)

• interest rates

• exchange rates, and

• general investor preference and sentiment.

The popularity of negative gearing investment strategies (where investors offset other income against interest deductions in the hope of recouping this loss through a combination of lowering their tax burden and capital gain on sale) is also likely to increase the cyclical nature of the investor housing market in particular.

Tenant demand for apartments can be unpredictable, due to the short nature of the leases.

Of course, the investor housing market can also impact the performance of the entire housing market, being a significant subset of the real estate sector.

The current risks in the investor housing market provide a useful backdrop upon which to consider the value of commercial property investment as a more-than-viable alternative.

Commercial property enjoys some significant advantages over residential property as a long-term property investment vehicle.

Commercial property investment is a viable alternative to residential investment apartments for small and larger investors alike.

These attributes include the following:

• Commercial property is higher yielding then residential, meaning:

• a higher proportion of the overall investment return comes from income return. This makes the return more manageable and more measurable; and

• a lower proportion of your total return is reliant on the vagaries of capital gain from the property market at any given time.

• Commercial property does not rely on trends and fashions – it is capable of being extensively analysed on the basis of the fundamentals of property investment.

• Commercial tenants tend to be of a higher quality than residential tenants in terms of risk profile. For example, commercial properties can be leased to established businesses with a track record of success – anyone from local businesses to multinational corporations can be your tenants.

• Commercial premises are typically leased for far longer periods then residential. A normal commercial lease can be anything from three years to 10 years (compared to a usual 12 month term for residential tenancies). This provides far greater certainty of an income stream for the investor.

• The old property adage of ‘location, location, location’ holds true for commercial property, probably even more measurably so than for residential property.

In order to profit from the palpable advantages which commercial property offers, it is vital that commercial property investment decisions are made on the basis of a proper analysis of fundamentals and rigorous due diligence. Established and well-considered property selection criteria provide a valuable benchmark against which to measure proposed commercial property purchases.

The advent of transparent, well-regulated and well-managed collective investment vehicles for commercial property has opened up opportunities for smaller investors to get involved in these often large-scale assets. Smaller investors can still benefit from the direct ownership attributes, including taxation efficiency and direct access to the commercial real estate market.

In a future article, I plan to reflect on the attributes of a well-considered commercial property selection process.  In the meantime, consider commercial property investment generally – it is the basis of many fortunes.

Steven Goakes