Rental property vs commercial real estate debt: which is the better investment?

Watching the fortunes of the housing market in Australia is something of a national sport and now more than ever as prices rally strongly through the pandemic and the economic recovery.

Official statistics show investors have been returning to the market in droves sending prices higher, as they search for an alternative to the low-interest rates offered on bank deposits and other fixed-income investments.

In September, investor housing loans across Australia rose another 1.5% and have nearly doubled over 12 months. (1)

Real estate has long featured in Australian investment portfolios. But it isn’t without risk, so it’s worth considering the best way to access the market.

The traditional way is through purchasing a house or apartment and renting it out to tenants, though this has not been achievable for all investors because of the significant capital outlay needed, and it concentrates risk in one asset, geographic location, and property type.

It has also become a lot more expensive, with average property prices 20 per cent higher in the 12 months to October, according to CoreLogic. (2)

Another option is available that allows self-managed super funds and other self-directed investors to invest in the commercial property market via a portfolio of loans diversified by market segment: residential development, land subdivision, industrial, hotel, retail etc, and geographic location.

This avenue has demonstrated it provides attractive, regular income while preserving capital compared to volatile equity markets.

Let’s compare the two options.

Buying an investment property

Self-directed investors tend to invest in residential property, in contrast to institutional investors who focus on the commercial market.

That’s partly because of the significant tax advantages applied to the residential sector, especially negative gearing, but also because of familiarity and affordability versus commercial property.

While rent from an investment property can deliver a predictable monthly income if interest rates rise or inflation increases, your real net income will fall unless you can negotiate a higher rent with the tenant.

Investment property owners are exposed to the ups and downs in housing prices that have been well demonstrated over recent years. According to CoreLogic, average housing values are up 20.63% in the year to October,(2) buoyed by the economic recovery.

However, it’s easy to forget that two years ago, the market was down more than 8% from its peak(3) following a sharp correction driven by tightening in the availability of credit as regulators implemented measures to reduce the risks in the mortgage market, causing a fall in lending to investors.

Last month the Australian Prudential Regulation Authority increased the interest buffer for new owner-occupier loans, in a sign they are again concerned about the risks to the economy of high loan-to-income ratios and high prices for residential property.

Investors who buy rental properties aren’t property market experts, yet they need to make crucial decisions as if they are – knowing where to buy, how much to spend and avoid overpaying, detecting any structural issues with the building, assessing the amount of rent they’ll be able to obtain on any given property, the list goes on. If they are buying off the plan, it can be even more complicated.

Because most investors can’t afford to buy an extensive portfolio of properties, the risk is often concentrated in one building, in one suburb, and one sector of the property market.

If the suburb falls out of fashion, the property is impacted by a nearby development, there are unexpected maintenance costs or the sector is impacted by a macroeconomic factor (such as tax changes for residential property), the impact on the individual’s broader investment portfolio is unhedged and can be significant, if not devastating.

As well as the costs of buying, financing, and maintaining a property, its expensive to get in and out because of stamp duty, agents fees and legal costs. It also takes weeks or months to sell a property.

During the onset of the COVID-19 pandemic last year, we witnessed extreme levels of illiquidity when there was very little activity in the market due to the uncertainty over the economic outlook.

Investing in commercial real estate debt

Managed funds that invest in commercial real estate (CRE) debt provide diversification for investors through exposure to a range of commercial property sectors traditionally dominated by wholesale investors, such as residential high-rise apartments, industrial warehouses, office buildings, and shopping centres.

Well-managed CRE debt funds are also diversified across borrowers, market segments and geographies, reducing an investor’s risk in order to deliver reliable returns and protect capital.

CRE debt is less exposed to property price volatility and any late-cycle correction. It is a lower risk investment than equity because Australian corporate insolvency laws give priority to the interests of creditors in claims over the assets of a business.

The average national gross residential housing yield in Australia in September was 3.29%.(4) By comparison, well managed CRE debt funds are returning interest of 5% to 8%.

In recent years, select opportunities have become available to retail investors in the Australian market, via credit-focused listed investment trusts (LITs) and unlisted funds.

Listed trusts provide daily liquidity, similar to shares, so if for any reason an investor needs access to capital, they can sell their fund units on the Australian Securities Exchange. Well-diversified unlisted funds can offer liquidity on a monthly basis.

Like an investment property that provides regular rent, CRE debt delivers regular income. The returns on CRE debt are based on interest and fee payments received from borrowers at specified intervals under the binding terms of their loan agreement.

However, unlike most rental income, CRE loans are structured with a floating base rate, as well as an additional credit margin, ensuring that total interest income rises in line with upward movements in market interest rates.

While it is crucial to choose a good quality lender, investors in CRE debt funds do not need to be experts on the property market or on debt.

They can rely on the expertise of experienced private debt fund managers to attend to all the risks associated with constructing the portfolio, including, understanding the macroeconomic pressures facing individual market segments; assessing the CRE asset or project; assessing the credit quality of the borrowers; structuring and negotiating the terms and conditions and security for each loan; and monitoring and management of the loan until it is repaid.

Fees charged by a fund are clearly defined upfront, with none of the unexpected costs faced when owning an investment property such as maintenance or repair costs.

At a time when property prices have run very hard, creating downside risks for investors, private commercial real estate debt funds arguably provide a better opportunity for those wanting real estate exposure.

They are more affordable, diversified and professionally managed to protect capital and provide a steady income. 

Looking for higher-paying income rates than the major banks?

Metrics Credit Partners is a leading Australian non-bank corporate lender and alternative asset manager. Metrics provide regular and consistent income to investors through its portfolio of corporate loans.

Visit our website or use the ‘contact’ button below for more information.

(2) CoreLogic, Hedonic Home Value Index, September 2021

(3) CoreLogic Hedonic Home Value Index, June 2019 Results, Released 1 July 2019

(4) CoreLogic Article, 26 October 2021
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