The news is mostly bad for commercial property investors

Commercial property

All investment asset classes move in cycles. Investment returns are almost never linear. As such, investors must expect good and bad periods, which is why patience and discipline are big contributors to an investor’s success.

I suspect that commercial property investors’ patience and discipline are about to be tested. This asset class is facing a lot of challenges. However, as they say, every cloud has a silver lining so there could be good investment opportunities over the coming months and years.

What challenges is commercial property facing?

Commercial property was the asset class that was the most adversely impacted by Covid lockdowns, especially the retail and office sectors.

Commercial property landlords had to provide rent waivers and reductions to retail tenants to help them through lockdown periods. But, unfortunately, not all retail businesses survived which increased vacancy rates.

Employees were also encouraged to work from home for long periods of time. This experience demonstrated that people did not necessarily need to be in the office full-time. As such, most of the office workforce has adopted a hybrid work model that involves working from home 2 to 3 days per week. The consequence of this is that large employers have reduced their commercial office footprint. In addition, businesses have been less inclined to commit to new leases until they can ascertain what long-term working arrangements may look like.

The upshot of this is that tenant demand for office and retail property is very low at the moment.  

That said, things are changing – albeit slowly. More employers are demanding that their workforce spend more time in the office. nab is probably the largest corporate leading this charge demanding all senior managers work from the office 5-days per week. I expect other large corporates to follow, especially if the unemployment rate normalises (it’s currently 3.5% – the normal level is circa 5%).

But the real problem is cap rates!

Cap rates is an abbreviated term for capitalisation rate. It is the key component used to value commercial property. Unlike residential property, the value of a commercial property is dependent on the rental income that a property generates (whereas residential property is driven more by the value of the underlying land).

Therefore, to value a commercial property, you must apply a cap rate to its income. The cap rate is the amount of return that an investor demands to invest in that property.

For example, if investors demand 5% income return from property and a particular property generates $100k of net rental income per year, then its technical value is $2 million (being $100k divided by the cap rate of 5%).

Cap rates are influenced by several factors, but the main influencer is the levels of income offered by alternative investment asset classes. For example, if term deposits (which are risk-free) are paying 4.5% p.a., then you probably want circa 6.5% p.a. or more to invest in commercial property, to be compensated for the higher risk.

When interest rates were very low (only 18 months ago), investors were searching for assets that paid higher income, such as commercial property. Investors were prepared to accept lower income returns from commercial property. Last year, cap rates in Melbourne and Sydney typically ranged between 4.25% and 5.50% for office property.

However, now that you can earn more than 6% from investing in a big-4-bank bond (which is virtually risk free), commercial property cap rates must increase.  

Using the example above (i.e., commercial property worth $2 million on a 5% cap rate), if we assume the market cap rate rises to 7%, the same commercial property would be worth about $1.4 million, which is a 30% reduction in value!

This is the biggest risk facing commercial property valuations – a rise in cap rates.

Industry super funds face a day of reckoning

Have commercial property valued fallen due to higher cap rates? Not yet. There’s been a bit of a Mexican stand-off between potential buyers and sellers. I have heard that some large super funds have tried to sell assets but only received offers that were 30% below the book value of the asset. Therefore, the super funds refused to sell, otherwise it would have to record a loss. Buyers don’t want to sell for less than they paid. But buyers don’t want to pay 2021-2022 prices.

This may come home to roost because all super funds must revalue their commercial property assets (in fact, all unlisted assets) at the end of the financial year. Technically, they should record a reduction in value. But whether this transpires, is uncertain as the sector lacks a lot of transparency and accountability, which I have written about in the past here.

Other unlisted REIT’s face the same issue.

But interest rates will probably fall…  

Comparing commercial property to investment-grade rated corporate bonds is a reasonable comparison. Why would I invest in commercial property if I can earn 6.0% to 6.5% p.a. from a very low-risk bond issued by an Australian bank? You wouldn’t.

But I think many new bond issues have been too expensive. The banks have had to offer higher rates of return because they had to raise so much money to repay the RBA. I don’t think it will be necessary for the banks to offer bond yields above 6% p.a. in the future. So, rates of return from alternative asset classes will probably contract.

Also, once inflation is under control, it is very likely that central banks will cut rates. The RBA estimates the natural cash rate to be circa 2.5%. The cash rate is currently 3.85% p.a. – a restrictive setting. If/when interest rates normalise, cap rates will adjust (which is positive for asset values). Potentially sellers are probably waiting for this to happen.

Not all real estate investment trusts are equal

The fact is that no one can predict which asset class will perform the best and worst over the short run. No one in the world has developed a reliable method for predicting this factor. Therefore, investors must spread their wealth across various asset classes. Asset classes will perform differently at different times. Therefore, you hope that diversifying your investments smooths your overall portfolio’s return.

Unlisted property trusts: make sure you have a good manager

If you have invested in an unlisted commercial property trust, I suggest making sure that the investment manager possess these positive attributes:

  • Experience and team stability. The risks that the commercial property market currently faces are not new. Commercial property has always moved in distinct cycles. Therefore, it’s important that your manager has seen it all before. Experience is key.
  • Given the pool of potential tenants has shrunk, it is important that your property offers something that differentiates itself. This requires a proactive manager and the right property that lends itself to improvement.
  • My concern with large institutional REITs is that no one has any skin in the game. The acquisition managers will do deals and then move onto a new employer – they may not stick around to take responsibility for the properties they buy. However, smaller investment managers are typically owned and operated by a small group of individuals. They depend on their good reputations to attract future investment dollars, so there’s a lot of skin in the game to ensure their investments perform well.

Listed REITs: stick to the global index

If you invest in listed REITs, it is best to use index funds. According to data provided by S&P Dow Jones, between 75% and 80% of actively managed REITs fail to beat the real estate index over 10 and 15 year periods.

The Australian REIT index has too much exposure to retail property on a look-through basis. Therefore, I prefer to invest in global REITs, as they have less exposure to retail property. I like Van Eck’s ETF (the code is REIT) and Vanguard’s fund which only comes in a managed fund format.

The good (or bad) news is that listed index REIT arguably already reflect the impact of higher cap rates. Vanguard’s fund has fallen 25% since the start of 2022 and Van Eck by about 30%. Therefore, arguably the bad news is already reflected in current prices.

Patience and discipline

Commercial property investors should prepare for bad news. However, if their investment is fundamentally sound, the best thing to do is exercise patience and discipline. In the long run, the asset class will generate good long-term returns, as it always has.