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The diversification strategy property investors overlook

Friday, 12th Jul 2019

Property has long constituted a popular form of investment in Australia, with its strong long-term performance and lower volatility in comparison to other asset classes leading many investors to recognise real estate as an important part of their wealth creation strategy.

However, whilst the majority of investors will gain exposure to real estate through residential property, very few achieve entry into the commercial property market. This is despite the fact that many investors recognise the importance of diversifying their portfolio in spreading risk, taking advantage of different wealth creation tactics and gaining exposure to alternative markets.

As an asset class, commercial property behaves differently from the residential market in many aspects. However, when combined into a diversified property portfolio, these very differences can also support the evolving needs of investors as they progress in their investment journey. So what are the key characteristics of the two asset classes? And how can they work together to help investors achieve their long-term financial goals?

Residential property – accumulation phase

Residential property has historically recorded higher growth rates than commercial property, and is therefore typically regarded as the preferred investment choice for property investors in the accumulation phase of their property portfolio. For this reason, most investors will start their investment journey in the residential sector, with the idea being they will leverage capital growth from these higher-growth properties to build and expand their property portfolio.

From a cash flow perspective, residential properties will generally provide a lower rental return than commercial assets, with the typical net rental income ranging from 3-4%. This is due in part to the high proportion of costs borne by residential landlords, with owners usually being responsible for ongoing expenses such as maintenance, rates and land tax.

Whilst many residential investors will focus on long-term capital growth as their primary wealth creation strategy, investors with a higher risk tolerance may also look towards more aggressive equity-building strategies such as property development or residential development syndicates to accumulate wealth across a shorter time-frame. These strategies typically involve higher risk, but for those who have the capacity and appetite, can also carry greater return potential.

Commercial property – consolidation phase

As investors move further into their property journey, they will often look to balance or consolidate their existing portfolio with investments that offer stronger income returns.

Commercial property

When investors approach retirement, especially, their allocation to long-term growth assets will often decrease. At this stage, investors will generally require more passive income from their portfolio to supplement or substitute their wage income. This is when many investors will consider diversifying their property portfolio into commercial property.

Commercial assets typically have a stronger cash flow focus than residential properties, and their value will largely be based on the income return they provide to investors (known as the ‘capitalisation rate’). The higher yield of commercial properties, which typically range between 7-9%, is largely due to the fact that commercial investors are able to pass on their rental outgoings as part of their rental rates, with tenants typically responsible for expenses such as land tax, council rates and maintenance.

Another reason that commercial property is often an attractive option for yield-focused investors is the length of commercial lease agreements. Whilst the typical length for residential lease agreements is around 12 months, it’s not unusual for commercial properties to have an initial lease term of five years or more, often with the option to extend this further after the initial term.

This longer lease term can be highly beneficial in providing investors with a stable income stream without the need to renegotiate lease agreements and replace tenants on a regular basis. However, the risk of this is that it can be considerably harder to secure new commercial tenants once another vacates, hence vacancy periods can be longer with commercial assets. For this reason, a strong property management strategy is critical in mitigating the risks involved in commercial property.

Accessing commercial property

With the right management strategy and risk mitigation strategies in place, commercial property can be an incredibly valuable addition to your property portfolio. However, there are understandably a number of roadblocks that prevent investors from gaining exposure to the commercial sector. With high-quality commercial assets typically priced in excess of $5 million, the high entry costs mean that few investors have the financial capacity to access this asset class directly.

With an increasing number of investors recognising the strategic benefits of diversifying into commercial property, a growing number of buyers are turning towards joint investment opportunities as a means of overcoming these high barriers to entry and accessing opportunities in the commercial market

Commercial property trusts can offer investors the opportunity to enjoy the asset performance of larger and high-quality commercial assets with the benefits of lower barriers to entry and (amongst others) the guidance of a professional management team. These investments can hold a number of advantages when it comes to achieving diversification whilst also minimising the time and research involved in commercial property investment.

Are you suited to commercial property?

Like any investment, a number of factors must be considered before deciding whether commercial property is the right strategy for you.

If you would like to find out more about commercial property trusts and whether this investment option could be a good fit for your property investment strategy, get in touch with our team via momentumwealth.com.au or contact our sister company, Mair Property Funds, for more information.