'Savvy investors': Increase your income, despite decreasing rates
Service stations and quick service restaurants are not typically front of mind when everyday investors think about investment income. So why are yield hungry investors pushing so hard to buy these types of assets?
A couple of weeks ago there was an article in the Australian Financial Review titled “Savvy property investors are filling up on service stations”, the article highlighted that:
The coronavirus pandemic created torment for commercial property investors with many sectors still facing uncertainty, but there were few sectors that defied the broader market… The pandemic showed just how resilient service stations are as an investment.
As we all know, the total return from an investment has two components – capital and income return. Whilst capital returns are more speculative, investors want their income generating portfolio to be much more predictable. We’ll talk about the importance of both.
COVID-19 again highlighted the resilience of Fuel, Convenience and Quick Service Restaurants
In the 1970’s there were over 25,000 service stations in Australia, today there are around 6,500. This is despite the Australian population essentially doubling from 13 million to 26 million, registered vehicles increasing from 1.4million (1955) to 19.8million (January 2021) and the national demise of the ‘milkbar’ for your everyday convenience items. So whilst service stations can be fantastic long-term investments, active management and strategic site selection is of utmost importance.
Fawkner Property has long viewed certain high-quality service stations with ancillary offers such as quick service restaurants as recession resilient investments. These assets have high barriers to entry, high replacement costs, strong and long covenants to some of Australia’s best retail operators and inelastic demand for petroleum products, day-to-day consumer goods, convenience, and fast foods.
It seemed that many of these defensive characteristics were not recognised by the market more broadly until State and Federal Governments mandated the closure of non-essential businesses in the wake of COVID-19.
Service stations, along with supermarkets and pharmacies, were forced to remain open given the critical infrastructure and services they provide to our communities. Such responses were also required during previous crises, for example, the 2019-2020 bushfires where service stations were used as community depots for State Emergency Services.
Institutional Investors buying up
In recent years savvy Retail and Institutional investors have recognised the defensive characteristics of these assets and in 2020, the value of long-leased convenience assets increased drastically. In a world where income returns have moved close to 0%, investors have scurried to buy investments that offer a high and also defensive income stream.
As highlighted in the AFR article:
Service stations “delivers a sound investment thesis because of historically long-term leases, consistency in performance (and) the added drawcard of future development potential thanks to their often-coveted, or high-profile, locations.
Whilst the press has spoken at length about high-net-worth investors buying up service stations, large institutional investors such as Charter Hall and GIC (Government of Singapore Investment Corporation) have made significant investments into the sector to capitalise on these defensive characteristics.
In 2019, Charter Hall completed an $840m deal to purchase a 49% stake in 295 long WALE assets. In 2020, Ampol announced that it had sold 203 convenience retail sites to the institutional consortium for $682m. The sale reflected a weighted average capitalisation rate (“Cap rate”) of 5.5%. The properties will be subject to CPI annual rent reviews, with minimum 2% increases per annum (if CPI remains below 2%).
This purchase cap rate of 5.5% is attractive given the 9 most recent on-market transactions had an average cap rate of circa 4.4%.
Fawkner Property has a $400million portfolio of high-qualtiy roadside retail assets with our latest trust having an average purchase cap rate of 6.4%, much higher than market comparables.
What’s that got to do with predictable investment income?
For predictable investment income we typically think two main risks, Default Risks & Interest Rate risks.
Default Risk: For a property investment, the income return is derived from the rent paid by the tenant (less the costs such as statutory charges and interest paid on the loan). Therefore, the default risk is that the tenant goes broke and cannot fulfil the lease obligation of paying rent. For service stations, this is low when the tenants are major corporations (such as BP, 7-Eleven, Liberty Oil, McDonalds, and KFC).
Interest Rate Risk: in very simple terms when interest rates go down, Cap Rates compress and the value of real estate increases. Conversely, when rates go up, the inverse tends to happen. Interest rates tend to go up when inflation increases (note in Australia inflation has persistently been below the RBA’s targeted band of 2-3% and as a result the RBA has committed to historic low interest rates for at least 3 years).
Given that inflation will eventually return at some point it is of integral importance to purchase assets that can increase their income over time to offset rises in interest rates. For service stations, rents typically come in two forms:
- CPI Rental Increases
- Fixed Rental increases
Fawkner Property’s latest convenience Trust offered investors a portfolio of high-quality service stations that had:
- 12-15 Year Leases: Brand new service stations with long WALEs to leading Australian retailers Liberty Oil (ASX listed), 7-Eleven and BP. All who adapt very quickly to changing consumer demands.
- 6.4% average purchase Cap Rate
- 3% Fixed rental increases
While differences between purchasing assets on cap rates of 4%, 5% or 6% may seem small on face value, it can have a major impact on future returns over the long-term. 'Back of the envelope' calculations below highlight different return scenarios over time:
As the chart shows, the difference in rental increases creates a significant return differential from years 1 to 9. This is exacerbated in year 10 as the Scenario 1 capital increase is much greater given the better initial purchase price. The above scenarios calculate total return on a geared portfolio.
As a result of the high-quality tenants such as 7-Eleven, BP, McDonalds, Hungry Jacks, Liberty Oil and Carls Jnr, Fawkner Property was able to collect 99% of rent during 2020 and continue to pay undisturbed monthly distributions. If you are looking for a defensive monthly income steam, underscored by high quality national and international companies, please contact us here.
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Shane Wakelin is a Director of Fawkner Property. Fawkner Property is an Australian-based fund manager that invests in Essential Service real estate. Simply put, we deliver our investors consistent, reliable monthly income.