By CHRIS RYLANDS
PRINCIPAL, WEALTH ADVISORY
Chris.Rylands@williambuck.com

In the first part of our commercial property sector review (here) we discussed sector valuations in a historical context. We concluded that that the low interest rate environment would sustain a level of demand, however the scope for further material price appreciation appeared limited.

 

In Part 2 we will examine the common risks associated with investing in a commercial property fund. A commercial property fund allows an investor to achieve a level of diversification and scale which is difficult to achieve as a single, stand-alone investor.

Property Market Risk

The primary risk for any investment is the specific market risk. The price of a commercial property is affected by a number of factors; including the demand for a particular type of property compared to future supply. The rental income is subject to the demand by tenants for commercial space and tenants’ ongoing ability to make rental payments.

Property expenses vary over time and may include capital improvements and ongoing expenses for general maintenance and repairs.

The current commercial property cycle is now over eight years old, implying market related risks are growing higher.

Gearing risk

Gearing magnifies both gains and losses on a property investment. A fund with higher gearing may experience larger fluctuations in value compared to funds with lower levels. A higher gearing level can create the illusion of superior returns.

The following example illustrates the impact of gearing on a fund’s equity when property prices change. Consider a scenario where a fund purchases a property for $1 million using a loan of $650,000, equivalent to a Loan to Valuation Ratio (LVR) of 65%.

 

Assumptions

$

  10% increase in
property value
$
  10% decrease in
property value
$
A Property Value    $1,000,000.00     $1,100,000.00         $900,000.00
B Loan $650,000.00  $650,000.00  $650,000.00
Investor Equity $350,000.00  $450,000.00  $250,000.00
B/A Loan to Valuation Ratio 65% 59% 72%
Return on Equity 29% -29%

 

The example illustrates the power of gearing.  A +/- 10% return on the property translates into a +/- 29% change in the value of the investor’s equity. Gearing works well in a rising market, but can be equally damaging in a falling market.

Investors should look for investments with lower gearing or look to reduce gearing at this point in the cycle. This will reduce the impact of falling prices on equity values when the cycle begins to turn.

Distribution Risk

An investor should look closely at the composition of any income distributions received from a fund. It is often easy to assume the income received is only the rental income remaining after expenses.  Unfortunately, this is not always the case.

A commercial property fund may distribute other forms of capital which creates the illusion of a higher yield. A higher yield is more attractive to investors in a low interest rate environment.

For example, a manger may draw down additional capital from the loan secured against the property to “top up” the distribution.  This reduces the value of the investment as the investor is receiving a portion of their own capital back.

Interest Rate Risk

Changes in interest rates may affect the amount of income available for distribution. Rising interest rates may require rental income to be diverted from distributions to pay the higher interest expense.

Interest rate risk can be migrated on some level by fixing the interest rate for a period. However, the fund may be unable to refinance a debt facility on agreeable terms when the current loan agreement expires.

Liquidity Risk

Commercial property transactions occur in an unlisted market and the asset class is considered illiquid. This means an investor does not have immediate access to their capital.

Selling commercial property generally takes three to six months and may take longer in a market downturn. The lack of liquidity in the property markets means an investor is unable to readily react to changing market conditions by selling an investment.

Manager Risk

An investor in a fund delegates the day to day management of a property to an investment manager.  As a result, the fund is reliant on the manager’s experience and skill. An investor should ensure that thorough due diligence is completed on a manager prior to investing.

Key areas include the key personnel’s background, the organisation’s investment track record and governance structure.

An investor is relying on the manager to mitigate the key risks discussed above. Poor investment management can lead to substandard investment outcomes, even when the overall market is rising in value.

In Part 3 of our commercial property focus we will conclude our analysis with a discussion on the outlook for the sector and how this is reflected in our current asset allocation and portfolio construction.