What are the relative attractiveness of commercial property investments? Rowan Wall

Commercial property in sound locations with long-term leases to secure tenants should be increasing in value as interest rates fall and new stock diminishes.  The following article highlights trends over the last four years that will enhance the relative attractiveness of commercial property investments.

It shows how the income return on capital invested in a commercial property investment has increased from 8.4% to 14.3% over the same period.  The return on fixed-interest investments has fallen from around 7% to 3.2%.  

If you purchased a government bond earning 5% per annum over five or six years and interest rates fell as they have done recently to 3% per annum, then the value of your government bond would rise by about 10%.  This is because the government bond that you hold is earning 2% more each year than new bonds on issue.  

Commercial property is usually on longer-term leases and the tenant usually per annumys most of the outgoings, thus net rental income should be more predictable over a longer term. 

For example, a property in Wollongong is leased-out to Government tenants for seven years.  On commencement of the lease, net rents represented 8% of the value of the property and rose by 4% per annum.  This 8% is called the cap rate.

As interest rates fell over the last few years, the value of the property should have risen because the net rental return had an increasing premium over the prevailing level of interest rates.  This did not happen because the pool of willing buyers contracted and those remaining started to price-in a greater level of risk associated with vacancy or lower rental returns or lower sale value - at the end of the lease.  

Simultaneously, finance for such commercial investments became harder to source and shorter in duration and banks charged increased margins.  Margins on many commercial loans rose by over 2% in the last few years and the average length of loans reduced by 40%.  The increased margins meant that investors did not benefit from the full imper annumct of the general reduction in interest rates. 

For example, in late 2007 the prevailing interest rates on a five-year loan was 7% and the bank margin was as low as 0.6% giving the all-up cost of finance at 7.6% per annum.  

Today the loan is likely to be for only three years at 3.2% per annum and the bank margin would be around 2.5% giving an all-up interest rate of 5.72% per annum, an effective drop of only 1.9% per annum.  

With fewer new investors and greater attention to the risk associated with vacancy or the expectation of lower rental returns at the end of the lease and tougher finance conditions, the level of net rental return (Cap Rate) demanded by investors rose. 

In our example, the required level of return needed to attract a purchaser exceeded 10%.  This meant that in order to achieve this 10% return, the property dropped in value by 20%.  

These lower property values were then reflected in lower valuations of the properties. 

With lower valuations, banks started to demand borrowers reduce their loans.  If the loan-to-valuation (“LVR”) requirement was 60% (ie borrowings represented 60% of the property value) and the valuation fell by 20% then the bank would demand that the loan be reduced by 20%. 

Those investors who repaid the debt benefited from a reduced amount of interest paid to the bank on the reduced loan, while continuing to receive net rental distributions equal to or greater than (due to the indexation) the level they received prior to the devaluation of the property. 

Unfortunately many investors were unable or unwilling to reduce the bank loan despite cashflows being enhanced, thus the properties were put on the market and sold at the reduced levels.  

New investors are now benefiting from higher net rental returns, lower interest rates and diminished supplies of competing stock. 

In the above example, the net rental return is around 10% and the cost of finance was 5.7%.  Therefore the new investor is making a return on the borrowed portion of the property of 4.3% (10% minus 5.7%) interest and a return of 10% on their own capital, giving a total return on their own capital of 14.3% per annum.