Commercial property isn’t a pure income asset class like cash or fixed interest but it has a few advantages over other forms of income-based investing, starting with the yield. Right now, the APN AREIT Fund, for example, offers a distribution yield of 6.08% (1), paid monthly.
Of course, the associated risk is greater than a term deposit but it’s typically lower than the kind of yield you might get from Woolworths or the big banks. That’s due to the structure of an Australian Real Estate Listed Trust (AREIT), formerly known as a property trust.
AREITs generate most of their income (circa 55-70%) from the rent collected from the tenants of the retail, office and industrial properties they own. The chart below shows total returns over five and 20 years by the Australian real estate sector.
Over a five to seven-year period we estimate investors can expect a 9-11% p.a return from AREITs, most of it derived from income, plus growth that typically equates to the rate of inflation. Recent returns have been greater, driven by lower interest rates and non-traditional investors seeking yield and capital insulation. An annual return of around 10%, however, remains a good rule of thumb.
For investors reliant on monthly income to cover day-to-day living expenses, this distinction between income and capital return is critical. Whilst company profits tend to fluctuate with the economic environment (and share prices are influenced by how investors value those profits) the situation of the landlord is quite different.
If, for example, Woolworths suffered a big financial loss, it may cut its dividend but is legally obligated to maintain its rental payments. Owning the landlord rather than the tenant makes a lot of sense for income investors, especially as AREITs own most of the best commercial real estate in Australia, leased to a diverse range of high-quality tenants. The result is an income stream you can rely on. Even during the global financial crisis, when many companies struggled, rent owed to AREIT landlords continued to be paid.
AREITs offer another advantage. A lease contract usually entitles the landlord to apply annual rent increases, either fixed or linked to CPI. Unlike bonds and fixed interest, AREITs have inflation protection built in.
Not that an AREIT distribution is risk-free. When a bank makes a loan of $100,000, it receives this principal as cash at the end of the loan term. There is no argument about how much that $100,000 is worth.
But the value of a property returned at the end of the lease (called a reversion), and the rent the landlord can expect to receive from the next tenant, is determined by the market. It is this uncertainty (risk) that makes commercial property a fundamentally different asset class to fixed interest.
This risk needs to be carefully managed but if you want consistent, relatively high levels of income, combined with some capital growth, AREITs are an attractive, proven option.
Of course, any investor can buy a few AREITs at the touch of the button through their online broking account, and yet many investors prefer to pay us to do it for them for the following three reasons:
1. Reduced hassle and portfolio management risk - We employ a team of dedicated property experts to find suitable opportunities and minimise risk through sensible portfolio management, always laser-focused on delivering reliable, sustainable monthly income. When you invest in the APN AREIT Fund you get instant diversification, not much paperwork and professional, proven management.
2. We know our way around the traps - Whilst AREITs tend to generate most of their income from rents, some generate a substantial income from riskier development and funds management activities. Such earnings can be far more volatile. Because our focus is on maximising investor income from Australian commercial real estate rents, we carefully assess and manage these risks.
3. Get a hidden tax benefit - Depending on your personal circumstances, investing in a property fund like the APN AREIT Fund can deliver tax-deferred income each year, improving your cash flow and delivering a more attractive after-tax return. That’s more money in your pocket rather than the Tax Office’s.
Three founding principles
Since the APN AREIT Fund’s inception on 19 January 2009, it has produced income of 8.35% p.a.(2) and a total return (3) of 13.77% p.a., at less-than-market risk. This is due to the application of three founding principles.
First, we recognise that leases and the rents they generate are a fundamental characteristic of commercial real estate;
Second, we avoid property investments that are more equity-like in nature, typically where significant proportions of revenue originate from non-rental sources (development and funds management); and
Third, we select investments that have long term utility, reducing the potential impact of lease reversion.
A good example of this approach is in the out-of-favour retail sector, which returned -0.9% over the year to April 2019. The office sector, meanwhile returned 35.8% and industrial a staggering 47.5%. Such a disparity brings opportunity and risk.
Retail is unloved right now with Stockland (SGP) perhaps the best example of it, returning -2.3% to April 2019 compared to the AREIT300 index return of 18.0%. The stock has also been weighted down by the falling residential market to which it has some exposure, however, the recent election delivered a strong rebound. Throughout a challenging year, Stockland offered a 7% distribution yield - handy while we waited for sentiment to change.
Scentre Group (SCG) is another example, currently trading at a 15% discount to its net tangible asset value and delivering a 5.9% distribution yield. Some local and suburban shopping centres are struggling but not Scentre, owner of the highest quality portfolio of retail shopping centres in the country. Just try visiting one on the weekend to see how popular they are, and how they’ve evolved into destinations to dine, relax, workout and learn rather than just shop.
The leading centres aren’t just changing from the inside, external changes are afoot. Vicinity’s The Glen in Melbourne, for example, is being upgraded with the addition of 500 apartments while hotels and office spaces are being incorporated into existing retail developments elsewhere, adding value and expanding the catchment.
You wouldn’t know it from sharemarket sentiment but high-quality shopping centres are thriving. Not only does this create individual stock opportunities, the sector divergence smooths returns over the longer term.
As for risk, look no further than industrial property owner, Goodman Group (ASX:GMG), currently yielding 2.2%, carrying a price-to-earnings ratio of 26 and a payout ratio just over 50%.
In effect, distributions are being withheld to grow the company’s development and funds management businesses, which now make up over two-thirds of its earnings. If this company were listed in Asia it wouldn’t qualify as a REIT. Unfortunately, many investors are unaware of the risks of Goodman’s skew towards non-rental income.
Our income focus, however, ensures we are under-exposed to it. This might impact our capital returns over the short term but it means our investors can be more confident of their regular, monthly distribution payment in the years to come.
This emphasises the approach of the APN AREIT Fund, closely replicating the risk and return of traditional income assets, making our investments in Australian commercial property truly property for income.
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(1) As at 30 April 2019.Current running yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.
(2) As at 30 April 2019. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indicator of future returns.
(3) Returns after all fees and expenses. Assumes distributions are reinvested. Investors' tax rates are not taken into account when calculating returns. Past performance is not an indicator of future performance.
I found the article interesting and thought provoking as it challenged a view I had. The chart you presented is confusing. You have presented three bars for 5 years and 3 bars for 20 years. Exactly what time periods are you referring to in this chart (eg. 2014-2019? and 2009-2014? - I'm guessing). What three 20-year periods and what three 5-year periods are you referring to ?
Hi Peter. The 5 and 20 year periods are to April 2019. The labels detailing each sector have not come through - the first two bars (5&20 years) are for retail, the next two office and the last two industrial. Regards Pete
Peter, I note your comments about expertise and knowledge your team provide in picking the portfolio but that comes with a cost. What are the annual fees you charge for your fund ?
Hi Tim. The APN AREIT Fund has a management cost of 0.85% p.a. Regards Pete