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Is it time to consider commercial real estate in the hunt for returns?

Is it time to consider commercial real estate in the hunt for returns?

By Luke Dixon, Head of Real Estate Research, AMP Capital

With Australian home prices falling, perhaps it’s time for residential real estate investors to broaden their horizons?

The love affair with real estate is ingrained into the Australian psyche. You can touch it, see it, drive past it and improve it.

But with home prices falling, policy questions over tax incentives and less availability of credit, perhaps the love affair with residential property investment is over.

So what does this mean for commercial real estate?

Real estate is commonly thought of as one big asset class that offers investors the same kind of returns.

However, there are crucial differences between commercial and residential real estate that mean what happens in one sector doesn’t necessarily ring true for the other.

Knowing these differences provides value-hunting investors with opportunities to exploit the market at different points in the cycle.

What are the differences between residential and commercial real estate?

One difference that is emerging at a rate of knots is valuations. The residential sector has entered what appears to be a prolonged downturn in pricing as the impacts of tighter lending standards and elevated apartment supply levels continue to bite.

In contrast, the commercial real estate sectors of retail, office and industrial are continuing to trade at strong valuations, as domestic and global investors continue to allocate more capital to this asset class.

There are two critical reasons for this.

  1. ASX-listed real estate trusts carry an average of 30% debt on their balance sheets, versus 70% plus for residential, which makes commercial asset values far less sensitive to interest rate movements and credit tightening.
  2. Globally, there is high investor demand for real estate assets that deliver more than 5% income and with income returns on commercial real estate in core office, industrial and retail markets typically averaging 5% to 7% over a cycle, this puts cashflow immediately into the hands of investors. This compares to less than 3% income which is typically generated on residential property, where investors tend to look for more capital growth.

Strong growth predicted for commercial real estate

As a result of falling home prices, we expect to see a rise in the demand for commercial real estate in the near to medium term.

Around 40% of Australia’s $5 trillion dollar residential market is owned by investors who rent out their properties. With the proposed changes to negative gearing and SMSF property investment, investors hungry for income are likely to start moving a significant amount of their capital to commercial properties.

And combined with the likelihood of interest rates cuts and global volatility, alternatives to real estate such as shares, bonds and cash start to look more volatile and returns uncompetitive.

What investors in commercial real estate should look for

Investors looking for income should look into whether local market conditions can deliver strong rental growth.

Regions with strong economies, low unemployment, positive business conditions and a diverse variety of tenants typically perform well.

Our own research indicates that the best results will come from:

  • prime offices in most major cities and urban fringes
  • inner urban logistics facilities
  • convenience-based retail properties like stand-alone supermarkets and neighbourhood centres.

Thinking beyond the traditional retail, office and industrial markets, investors will also benefit from a wider variety of asset types as the commercial market further deepens. Student accommodation, build-to-rent and self-storage facilities could all create more opportunity for investors to diversify and achieve better income returns.

Speak to your BFS Adviser and if you don’t have one but are after some advice, please contact us to speak to one of our team.

For more on economics, markets and investments, check out the AMP Financial help hub and AMP Capital website, or subscribe to AMP Capital insights for regular updates.

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