Understanding the terminology used in property investment is crucial for making informed decisions. This section will introduce you to some of the most common terms you’ll encounter in the world of commercial property investment. Whether you’re a seasoned investor or just starting out, having a solid grasp of these terms will help you navigate the complexities of the market and make informed investment decisions.
A trust that uses pooled investor funds to buy property assets, which the trust manages for a profit. A-REITs are listed on the Australian Securities Exchange (ASX), so investors can buy and sell shares in them like any other stock.
A measure used in real estate to evaluate the return on investment of a property. It is calculated by dividing the property’s net operating income (NOI) by its current market value or purchase price. The cap rate is expressed as a percentage and helps investors understand the potential income generated by the property relative to its cost. A higher cap rate indicates a higher potential return on investment, while a lower cap rate suggests lower returns.
In an investment sense, diversification means not investing all your money in one investment, and instead investing across different asset classes (such as shares, property, bonds and private equity), and investing in different options within each asset class. This allows an investor to spread their risk and reduce the risk of the portfolio underperforming as each investment can perform differently in different market conditions. Having a variety of investments with different risks and expected returns will balance out the overall risk of a portfolio.
Also known as leverage or LVR (Loan to Valuation Ratio), is a way to measure how much of an investment is financed using borrowed money (debt) compared to the equity contributed by investors. It is essentially the balance between debt and equity in an investment.
A risk management strategy used to protect against potential losses from unexpected market movements, allowing investors to manage their exposure and maintain more stable returns. With property assets, it usually involves locking in borrowing costs at a certain interest rate over a period of time. A fund might be 50% hedged, meaning that 50% of debt outstanding will be paid at a variable rate of interest, and the remaining 50% is locked in or capped at a fixed rate of interest.
Sign up for our Essential Guide to Investing in Unlisted Property series to learn the fundamentals of unlisted property trusts.
IDPS are managed investment schemes for holding and dealing with one or more investments selected by investors. An IDPS allows an investor to invest in a range of investment options across different asset classes, investment managers and investment styles.
The IDPS has custody of the investments with the investor having a beneficial ownership. Investments are legally held by a custodian or trust and not in the investor’s name. This means the investor does not have a direct unit or interest in the managed investments, and instead only has a relationship with the IDPS.
Examples of IDPS like schemes include BT Panorama, Macquarie Wrap, and Netwealth. For a full list of IDPS availability for CFM products see www.cromwell.com.au/invest/advisers/
It is an offer document produced for the sale of a product or asset to wholesale investors.
It is a financial metric used to evaluate the profitability of an investment. It represents the annualised rate of return that an investor can expect to receive over the life of the investment. The IRR is calculated by finding the discount rate that makes the net present value (NPV) of all cash flows from the investment equal to zero. In simpler terms, it’s the rate at which the present value of future cash flows equals the initial investment. The higher the IRR, the more profitable the investment is considered to be.
The ratio of a company’s loan capital (debt) to the value of its equity. Also known as gearing or LVR (Loan to Valuation Ratio).
Refers to how easy it is to convert assets into cash.
A unitised portfolio of property assets, listed on the Australian Securities Exchange (ASX). Also known as a REIT (Real Estate Investment Trust).
The ratio of the amount borrowed to purchase an asset (building/property) to the valuation of that asset. LVR’s can change over time as either (or both) debt increases or decreases, or the value of the asset increases or decreases.
It is the National Australian Built Environment Rating System used to measure a building’s energy efficiency, carbon emissions, water consumed, and waste produced, to produce star ratings which can then be compared to similar buildings.
Refers to the total value of a fund’s assets minus its liabilities. It is calculated by subtracting the fund’s liabilities (such as outstanding debts and expenses) from the total value of its assets (such as cash, investments, and other holdings).
For managed funds and exchange-traded funds (ETFs), NAV per share is calculated by dividing the NAV of the fund by the total number of units/shares outstanding. NAV per unit/share represents the value of each unit/share in the fund.
NAV is an important metric used by investors to assess the value of their investment in a fund. It provides insight into the fund’s overall financial health and can help investors make informed decisions about buying or selling units/shares in the fund.
Refers to the percentage of rented or leased space within a property compared to the total space available. It’s a crucial metric in real estate that indicates the level of utilisation and income generation for a property. A high occupancy rate suggests strong demand and stable income streams, while a low occupancy rate may indicate potential vacancies and reduced income.
It is a formal document that serves as a legal offer for a financial product. It provides detailed information about the features, risks, and terms of the product, helping investors make informed investment decisions.
They are pooled investments in real estate typically managed by a fund manager. They allow multiple investors to combine their funds to purchase a property that might be beyond their individual financial reach.
The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
A TMD describes who a product might be suitable for. It sets out the target market for the relevant fund as well as the distribution conditions, review triggers and other relevant information. It helps investors and advisers understand the class of retail investors who the financial product is likely to be appropriate for based on investment objective, proportion of overall investment, investment timeframe, liquidity requirements, and risk/return profile.
It is a type of investment that gives investors the ability to participate in commercial property assets by investing in a fund. Unlike publicly traded funds, unlisted property funds are not listed on stock exchanges, offering a different avenue for accessing property investments. Unlisted property trusts operate similarly to direct investments in commercial property but with the advantages of professional management and diversification. Learn more here.
It is a metric that indicates the average duration until all leases within a commercial property expire. It provides insight into the stability and predictability of income streams from the property’s leases.
A measure of returns to investors that is expressed as a percentage over a set period of time.
Cromwell continually strives to help securityholders and potential investors better understand the nature of the market – and our business – so that they can make more informed investment choices.
In Insight 47, we explored key excerpts from parts 1 and 2 of Cromwell’s The Essential Guide to Investing in Unlisted Property – a comprehensive series of papers that has been compiled to be a valuable resource for anyone seeking to diversify their portfolio and explore alternative avenues for growth through unlisted property funds and trusts.
In that article, we defined the different property asset classes, and investigated various ways to invest in commercial property. Now, in the second part of this series, we will explore the excerpts from the final two parts of the Guide.
Cromwell’s The Essential Guide to Investing in Unlisted Property is comprised of four parts:
Part 1 – The different property asset classes
Part 1 explores the differences between the residential and commercial property and provides an overview of the sub-classes of commercial property – retail, office, industrial, and specialist properties.
Part 2 – Various ways to invest in commercial property
In part 2 we examine different investment methods, ranging from direct property ownership to professionally managed property trusts.
Part 3 – How does an unlisted property trust work?
Part 3 provides insight into the structure of unlisted property trusts; the issuance of units; borrowing arrangements; property management; costs and fees, distributions; tax-deferred income; and the process of exiting your investment.
Part 4 – Reviewing an unlisted property trust
Before investing in an unlisted property trust, it is important to understand and review the provided Product Disclosure Statement (PDS) and Target Market Determination (TMD), particularly the ‘risks’ section, to fully comprehend the nuances of the trust and its assets. In part 4 we provide a summary of what to look out for.
Unlisted property trusts can only be offered by licensed managers, who are called the ‘responsible entity’ of the trust. ASIC issues the manager an Australian Financial Services (AFS) licence – and the manager has a fiduciary duty to act in the best interests of investors, including prioritising the interests of unitholders over their own interests.
This section of the Guide explains two key documents that managers must provide to investors:
A PDS and TMD must be provided for any type of trust you consider investing in, these being:
Fixed-term trusts
A fixed number of units are issued (usually at $1.00 each). The capital raising is completed when the full cost of the property, plus fees and costs less any borrowing, has been raised.
Open-ended funds
An open-ended fund continues to raise funds indefinitely so long as it can keep purchasing properties. Units will be issued based on a unit price, with the unit price based on the value of the fund’s properties and other assets. Unit pricing policies and frequency of issue will depend on the manager and fund.
A significant benefit of investing in an unlisted property trust is gaining access to the multi-faceted expertise of the manager. The best property fund managers have an internal property management division, which looks after the buildings in the trusts it manages. Having this function in-house ensures an alignment of interests between not only the manager and investors, but also tenants who are ultimately responsible for providing unitholders with real income.
Property management includes leasing, ongoing maintenance of buildings, building concierge services, fire safety, and other compliance requirements and – most importantly for you as an investor – making sure rent is collected!
The trust will receive rental payments from tenants and this is passed on, less any expenses, to unitholders as distributions on a regular basis. Depending on the trust, distributions may be paid monthly, quarterly, six-monthly, or annually.
Tax-deferred distributions
Tax-deferred distributions can be an attractive feature of many property investments and have the potential to increase the after-tax return of an investment. The benefits of tax deferral can be significant, especially for those with high incomes. For many investors, an investment that offers 100% or even 50% tax-deferred distributions can significantly enhance the after-tax returns from that investment.
The manager is critical when choosing a property trust. These are the people and organisations you are relying on – and paying – to carry out appropriate due diligence on the property asset, to build and manage the trust, and usually to physically manage its assets. In reviewing the manager, you should consider their experience and past performance, as well as whether they are financially secure; have good compliance process in place; are forthcoming with information; and more.
Among other elements, it is critical to consider the trust structure; distribution yield; and the property asset/s.
It is important to understand the trust structure to ensure the investment is suitable for your needs and anticipated outcomes. The product disclosure statement can be used to help you determine a) whether the trust fixed term or open-ended; b) what happens at maturity of the trust; c) how liquidity is provided (for open-ended trusts); d) how units are priced; e) how are properties valued; and more.
The distribution yield is the income you can expect to receive for every $1 of investment (e.g. a dividend yield of 6% per annum means you can expect to receive 6 cents per year for every $1 invested).
When reviewing the building(s) in a trust, there are a number of factors to consider and questions to ensure you have answers to before an investment is made. These factors include:
Understanding unlisted property trusts
For the full, unabridged version of parts 1 to 4 of the Essential guide to investing in unlisted property, please visit https://www.cromwell.com.au/real-expertise/investing-in-unlisted-property-trusts/
Read the full, unabridged version of parts 1 and 2 of The Essential Guide to Investing in Unlisted Property, as well as parts 3 and 4 in the series – ‘How Does an Unlisted Property Trust Work?’ and ‘Reviewing an Unlisted Property Trust’. Parts 3 and 4 of the guide explain unlisted property trusts in easy-to-understand detail. Download your copy for free today.
Colin Mackay, Research and Investment Strategy Manager, Cromwell Property Group
In our view, the commercial property market cycle includes four phases:
Peak: This phase features strong economic growth, rising property prices, and high investor confidence. Demand accelerates and vacancy rates drop well below normal levels. However, it can also lead to overvalued assets as sentiment moves ahead of underlying property performance and prices reach their zenith. Interest rates may also start to rise in this phase as the RBA seeks to take some ‘heat’ out of the economy.
Slowdown: In this phase, market dynamics shift, leading to weaker demand and softening prices. Construction, which typically picks up in the expansion phase, starts to create an oversupply and vacancy rates increase. Interest rates continue to rise, impacting jobs growth and slowing the economy. Sentiment worsens, perpetuating falling prices.
Trough: Characterised by low investor confidence and sometimes widespread despondency, this phase sees prices hitting their lowest point. However, it can also present opportunities for investors to buy undervalued assets at attractive prices. Towards the end of this phase, rate cuts often stimulate activity and lay the foundation for asset appreciation.
Expansion: During this phase, economic and financial conditions improve, boosting investor confidence and supporting asset prices. This is typically the longest phase, underpinned by moderate growth rather than the sentiment-driven extremes of the market peak and trough.
Property market cycles repeat over time, but each one is unique. This is because the intensity and duration of a cycle depends on a multitude of factors such as macroeconomic conditions, geopolitical events, investor sentiment, and unexpected occurrences like natural disasters or global pandemics. Sectors within a market and even different locations can be at different phases of the cycle at the same point in time.
Now that we have the basics covered, let’s take a look at the current property market.
As mentioned above, macroeconomic conditions play a big role in property cycles. Recently, we’ve seen a significant increase in interest rates – 425 basis points in 18 months, which has significantly impacted commercial property prices. However, many believe that interest rates have peaked for this cycle. Other countries such as the US, Canada, New Zealand, and several across Europe, have already started lowering rates.
Australia’s inflation cycle took hold around six months later than peer markets and rate cuts are also expected to commence a bit later (around early next year). Cromwell expects lower interest rates will boost market confidence, stimulate transaction activity and support property prices.
We’re starting to see signs that property prices may be stabilising. The pace of capitalisation (cap) rate expansion (a driver of declining property values) is slowing for retail and industrial properties, an indication that the cycle may be turning for these sectors. It is important to note that because the valuation cycle lags, waiting until market valuation cap rates have started to compress means the best buying (i.e. the bottom of the cycle) has actually already passed you by.
For office properties, cap rate expansion is yet to slow but should follow the example of retail and industrial, in part supported by the emerging cap rate differential to the other sectors, which will boost the relative attractiveness of office investment. Increased transaction activity is another sign that the market cycle might be turning.
While the macroeconomic and capital cycles appear to be becoming more favourable, they would be of little consequence if office market fundamentals were too far out of sync. Despite some challenges, like high vacancy rates in Sydney and Melbourne, there are still reasons for investors to be optimistic about the office market.
Firstly, rents are at cyclical lows, similar to the levels seen after the early 90s office market blowup. With rents at low levels, occupiers aren’t under financial pressure to reduce their space or avoid expanding if they’re growing. This also means that cutting office space or rent isn’t the first option for saving costs. Companies understand that losing staff or having lower productivity due to a poor work environment is a bigger risk to their profits.
The other cyclical element of office fundamentals is the development pipeline (i.e. supply risk). This is relatively small, with the amount of national CBD stock expected to grow by only 0.9% per year from 2024 to 20281, compared to the 20-year average of 1.6% per year2. It’s not practical to build new offices unless they are already under construction or part of an infrastructure project, due to low rents and high construction costs affecting profitability.
It’s unlikely this dynamic will be resolved any time soon, with construction cost inflation expected to remain elevated3 and state infrastructure pipelines set to continue outcompeting for scarce resources and labour for at least several years. The lack of new development is good for the performance of existing buildings, helping to balance supply and demand and support rental growth.
Over the past 40 years, investing in Australian office, industrial, and retail properties has generally paid off, with property values growing steadily despite facing a number of downturns and crises. While looking at a shorter timeframe will accentuate cyclical ups and downs, the market has shown a long-term upward trend.
Adopting a long-term approach when investing in property means investors can benefit from this steady growth. This approach helps avoid the stress of predicting market movements. Sticking to a disciplined, long-term strategy based on solid fundamentals can help investors navigate market cycles, reduce risk, and build wealth over time.
It’s hard to know exactly when any market will peak or bottom out, but there are signs that can give clues about the general position of the commercial property cycle – whether it’s falling, stabilising, rising, or peaking.
With rate cuts expected in 2025, financial markets believe the overall economic cycle is close to turning. Similar signs are appearing in commercial property, with slower cap rate expansion in some sectors and increased transaction activity. For office spaces, very low rents and limited supply are reasons for optimism and present a good buying opportunity.
For investors who have the courage and capital to buy now, the benefits can be significant. Attractive prices are available, with buyers able to take advantage of distressed sales and the gap between market fundamentals and sentiment. While choosing the right properties is still crucial for investment returns, getting in early and riding the market upswing can provide a strong advantage for investors. Those who have been patient and held onto their investments through this stage of the cycle are also likely to benefit.
Stuart Cartledge, Managing Director of Phoenix Portfolios
Capitalisation rates, commonly known as “cap rates”, are a fundamental metric in Australian property investing. When a commercial property is sold, two pieces of information will be widely reported. Firstly, the amount the property sold for and secondly, the cap rate. Often properties will be compared by their respective cap rates. Reports will often comment on the “implied cap rates” of different property securities. However, this seemingly simple and ubiquitous measure can be far more complex to use when comparing different types of properties.
Whilst different market participants may mean different things when referring to a cap rate, the Property Council of Australia (PCA) defines a cap rate as a property’s net operating income (NOI) divided by its property value estimate. For example, if a property generates an annual NOI of $500,000 and is valued at $10 million, the cap rate would be 5%. A purchaser might assume that they would receive a cash flow yield of 5% plus any rental growth that may occur. This isn’t necessarily the case and ignores key considerations.
Commonly, properties require meaningful ongoing investment, which isn’t reflected in the NOI used to calculate cap rates. This investment is known as capex and comes in many different forms. It may be maintenance capex, which refers to significant replacements or additions to maintain the standard of an existing building. For office properties, this may include replacing lifts or air conditioning units, each of which may need a full replacement as often as every 15 years. For shopping centre properties, capex may include items such as escalators or shared facilities such as bathrooms. Maintenance capex is not directly reflected in increased rent and is commonly used to “maintain” the relevance of an existing building. This amount is often referred to as a percentage of a building’s value. For example, if a building worth $100 million requires maintenance capex of $500,000 per year, it is common to say it requires 0.5% (or 50 basis points) of maintenance capex.
To attract and retain tenants, commercial property owners often provide “incentives” to prospective and renewing tenants. These incentives can take many forms, but are commonly provided as rent-free periods, or contributions to a tenant’s fit-out. The size and form of incentives varies greatly between different property types. Incentives are commonly quoted as a percentage of the total rent to be paid over the tenant’s lease period. For example, if a tenant agrees to a 10 year lease for $100,000 per year, a 20% incentive would mean that $200,000 of benefits are provided to the tenant. Rent, less any incentives is called “effective rent” and in the above example effective rent would be $80,000 per year. Rent excluding incentives is called “face rent”. It is typically face rent that is used to calculate the NOI used in a cap rate.
Whilst not the subject of this article, it is worth noting that lease structures including term and rent reviews, as well as tenant quality are not considered in a cap rate. Buildings with longer leases, higher fixed rent increases and better tenant quality tend to attract lower cap rates than the alternative.
In a past generation, institutional grade commercial property primarily consisted of office, retail and industrial property. Approximate leasing incentive and maintenance capex amounts across these subsectors 15 years ago can be seen in the table below:
| Property Type | A Grade Melbourne CBD Office Building | A Grade Melbourne Shopping Mall | Modern Melbourne Industrial Facility |
| Leasing Incentives | 20% | 0% | 5% |
| Maintenance Capex | 0.5% | 0.5% | 0.3% |
Whilst there are some differences between the amount of cash flow leakage, the difference between property types is not enormous. Whilst industrial properties faced limited cash flow leakages, market rental growth had been extremely low for a long period. It may not have been perfect but comparing cap rates across these property types 15 years ago was not a terrible way to assess relative value.
Beyond any changes to leasing incentives and maintenance capex requirements, today’s listed property sector is much broader than it used to be. Alternative property types such as healthcare, social infrastructure, petrol stations and long WALE sale-and-leaseback properties are all part of the institutional investment landscape. Many of these property types are commonly leased in an owner favourable “triple-net” manner. A triple-net lease means a tenant is responsible for property taxes, building insurance and maintenance capital expenditure across the life of the lease.
A revised table approximating today’s leasing incentives and maintenance capex, including triple-net properties, can be seen below:
| Property Type | A Grade Melbourne CBD Office Building | A Grade Melbourne Shopping Mall | Modern Melbourne Industrial Facility | Triple-net Property |
| Leasing Incentives | 42.5% | 15% | 10% | 0% |
| Maintenance Capex | 0.6% | 0.6% | 0.3% | 0% |
It is clear when comparing the above tables, that the dispersion in incentives and capex has widened materially. In the case of an A grade office building, the gap between the building’s cap rate and its true cash flow yield is vast. The chart below demonstrates this visually for an office building with a 6% cap rate:
As can be seen, the cap rate in no way resembles the true cash flow of owning an office building, with more than half of the NOI received (used in calculating the cap rate) lost to capex and incentives.
Consider the four assets in the above table. In this example, each has a cap rate of 6%. The chart below shows the cash flow yield of each:
Phoenix actively considers the factors affecting cash flows (among others) and explicitly forecasts longer term capex and incentives that property owners will be required to pay. It is these cashflows that determine value, not next year’s dividend or simply observing a cap rate.
A comparison of Dexus (DXS) and Charter Hall Social Infrastructure REIT (CQE) shows the importance of looking beyond headline cap rates and how this affects how Phoenix manages the portfolio. DXS is predominantly an owner of high quality office properties across Australia. CQE is predominantly an owner of smaller properties leased to childcare providers on triple-net leases. CQE’s cash flow is boosted by a lack of incentives and capex. Childcare property rent is also an income stream heavily supported by the government, with support for funding of the sector a politically bipartisan issue. As at period end, DXS’ office cap rate implied by its share price was greater than 8.3%. CQE’s implied cap rate was more than 6.8%. If one were to merely compare cap rates, DXS would be the more attractive investment opportunity. It however faces significant cash outflows (in the form of capex and incentives) beyond what is measured in a cap rate. As such, Phoenix has held no position in DXS for some time and holds an overweight position in CQE.
Cap rates have the benefit of being simple. In the past they were also a reasonable way to compare property. As incentives and capex levels have diverged between different properties, merely looking at cap rates has become a less appropriate way to consider the relative attractiveness of different properties. By developing a more nuanced understanding of what’s truly “in a cap rate”, investors can make more informed decisions. Remember, the devil is always in the details, and in real estate investing, those details often lie beyond the simple cap rate calculation.
Read more about Cromwell Phoenix Property Securities Fund, including where to locate the product disclosure statement (PDS) and target market determination (TMD). Investors should consider the PDS and TMD in deciding whether to acquire, or to continue to hold units in the Fund.
Cromwell continually strives to help securityholders and potential investors better understand the nature of the market – and our business – so that they can make more informed investment choices.
As such, we have compiled a comprehensive series of papers that form The Essential Guide to Investing in Unlisted Property, which is now available online. This information set will be a valuable resource for anyone seeking to diversify their portfolio and explore alternative avenues for growth through unlisted property funds and trusts.
The guide also highlights the key benefits of investing in an unlisted property trust, which include:
Cromwell’s The Essential Guide to Investing in Unlisted Property is comprised of four parts:
Part 1 – The different property asset classes
Part 1 explores the differences between the residential and commercial property and provides an overview of the sub-classes of commercial property – retail, office, industrial, and specialist properties.
Part 2 – Various ways to invest in commercial property
In part 2 we examine different investment methods, ranging from direct property ownership to professionally managed property trusts.
Part 3 – How does an unlisted property trust work?
Part 3 provides insight into the structure of unlisted property trusts; the issuance of units; borrowing arrangements; property management; costs and fees, distributions; tax-deferred income; and the process of exiting your investment.
Part 4 – Reviewing an unlisted property trust
Before investing in an unlisted property trust, it is important to understand and review the provided Product Disclosure Statement (PDS) and Target Market Determination (TMD), particularly the ‘risks’ section, to fully comprehend the nuances of the trust and its assets. In part 4 we provide a summary of what to look out for.
The first section of The Essential Guide to Investing in Unlisted Property clearly separates the property asset class into two groups – residential property and commercial property.
For the purposes of this article, we’ll highlight office properties, which fall within the commercial property class.
The fundamental difference between commercial and residential property is that commercial properties are usually valued based on the income return they will provide to an investor, which is known as the capitalisation rate (cap rate) or yield.
For example, if an A-grade office building typically trades at a cap rate of 7% at a given point in time, then the market value will be calculated using the formula: income/cap rate = value. So, for a building generating an income of $1,000,000, its theoretical value would be $14.3 million (i.e.,$1,000,000 / 7%).
The value is also affected by additional factors, including the lease terms, quality of tenant, and other building attributes. Management expertise is an essential consideration with commercial property, as there are undoubtedly more issues to be addressed compared to residential property.
Tenants, particularly government or large corporate tenants, have specific and often complex needs that may include how their leases are structured to ensure better funding or tax outcomes.
Compliance requirements, such as Occupational Health and Safety, are also a significant burden to commercial property owners, and understanding the applicable regulations and associated costs is essential. For these reasons, most commercial property owners use professional property managers, which should be a core part of a property fund manager’s business.
From a yield perspective, office properties can vary substantially. There is a substantial difference in the yield you would expect to receive from a premium-grade building (low yield) compared to a C or D-grade building (high yield). Other factors which can affect yields include the location of the property, the tenants and length of lease.
Premium-grade property is not necessarily a better investment than a lower grade building; however, it does tend to attract more financially secure tenants, which lowers the risk for investors. As office buildings are rarely located in isolation, it is important to review the supply and demand characteristics of the area in which the property is located to ensure long-term demand for space in your building.
In recent years, government and blue-chip tenants have increased their demand for newer, environmentally sustainable office buildings. This is a vital consideration when assessing the long-term outlook for office properties.
Office buildings in Australia are classified under a voluntary, market-based system developed by the Property Council of Australia (PCA). The PCA’s Guide to Office Building Quality provides two classification tools – one for new buildings, and the other for existing buildings.
The Guide classifies office buildings into Premium, A and B grades for new buildings and additional C or D grades for existing buildings – according to their size, location, configuration, environmental performance, communications, security, lifts, air conditioning, as well as other services and amenities.
To earn a Premium classification, a new building would need to be a landmark office building located in a major CBD office market with expansive views and outlook, ample natural light, premium quality finishes and amenities, and a 5-Star or above National Australian Built Environment Rating Scheme (NABERS) Energy rating.
It would also need to have a minimum net lettable area (NLA) greater than 30,000 square metres (sqm) if in Sydney or Melbourne.
The criteria to earn a Grade A classification is less stringent, but still requires a building to have high quality views, lifts, finishes and amenities, a 4.5-Star or above NABERS Energy rating and a NLA over 10,000 sqm if located in major capital CBDs.
B-grade buildings are required to be ‘good quality’ with a minimum 4-Star NABERS Energy rating.
Existing buildings are rated on slightly different parameters with additional categories for C and D-grade buildings. The ratings acknowledge that existing buildings will not be as energy efficient as new buildings, but reward owners and tenants for taking steps to improve efficiency.
As the title suggests, the second paper in the guide closely explores the options that everyday investors have to enter the commercial property market. These options include:
Purchasing a property directly yourself, with or without borrowing, is commonly used for residential property investment. For commercial property, however, this is usually only an option for very wealthy investors.
Sometimes a group of investors get together to pool their money and buy a property. In this case, there may be limited legal agreements and professional involvement around the choice of assets and their management. This type of investment generally requires a substantial level of investment by each investor, and may or may not include borrowing.
A property investment can be made through a professionally managed investment trust which is regulated by the Australian Securities and Investments Commission (ASIC). In Australia, there are two major types of property trusts: Australian Securities Exchange (ASX) listed Real Estate Investment Trusts (A-REITs) and Unlisted Property Trusts.
Property trusts listed on the ASX used to be called listed property trusts but are now more typically known as ASX listed Real Estate Investment Trusts (A-REITs). They invest in a wide range of commercial property types and can be traded just like any other share. The wide variety of A-REITs available, the large asset diversification generally within each A-REIT, and their high level of liquidity are strong positives.
Unlisted property trusts provide an investment with characteristics most like a direct purchase of a commercial property, with the added benefit of professional management. As unlisted property trusts are generally priced based on the underlying valuation of their assets, their price volatility is a lot lower than A-REITs and the value of the investment is primarily influenced by movements in the commercial property market, rather than by the broader share market.
Read the full, unabridged version of parts 1 and 2 of The Essential Guide to Investing in Unlisted Property, as well as parts 3 and 4 in the series – ‘How Does an Unlisted Property Trust Work?’ and ‘Reviewing an Unlisted Property Trust’. Parts 3 and 4 of the guide explain unlisted property trusts in easy-to-understand detail. Download your copy for free today.
Cromwell’s Investment Manager, Lachlan Stewart, is an experienced commercial real estate professional, who has spent more than 20 years working for highly respected organisations, including Colliers International and GE Capital Real Estate. He specialises in property valuations and financial modelling.
Section 601FC(1)(j) of the Corporations Act imposes an express obligation on a commercial property owner to ensure that the scheme property, which includes any real estate, is valued at regular intervals appropriate to the nature of the property. A company can decide to internally value or externally value a property.
As such, a commercial property valuation is the most reliable way of determining the market value of an income-producing property – it serves as an important, professionally backed tool for owners, investors, banks, regulators, and other interested parties.
Unlike residential property, commercial properties can be complex in the way that they are valued, given that every commercial opportunity is driven by a different set of needs and unique contributing factors. These factors will be explored in greater detail below.
External valuation services
To undertake a property valuation of an asset, building owners engage external, independent commercial property valuers. These valuers generally:
Internal valuations
In some instances, building owners may choose to conduct an internal valuation. A company’s Board may value a property itself where, in its reasonable opinion, it is not necessary or not practically possible for a valuation to be obtained from an external valuer. This valuation type typically uses the same methodology and metrics as independent, external valuations.
There are two main methods of valuation that are routinely applied to the asset valuations in Australia – the income capitalisation approach and the discounted cash flow approach. It should be noted that there are other methods of valuation, but, for the purposes of this article, we will examine these two most common methods.
Income capitalisation approach
The income capitalisation approach to property valuation examines the net income a property would achieve in an open market – regardless of whether it is leased or vacant – divided by the appropriate capitalisation rate, to give the core value of the asset.
The capitalisation rate (cap rate) (yield) is the component that moves with market forces, such as interest rate changes, economic growth, vacancy rates, inflation, and lease covenants. The capitalisation rate is similar to the price-earnings multiple, often used when valuing shares. Valuers will also look at the capitalisation rates of comparable sales over the previous 12 months when calculating the market value of an asset.
In example 1 consider a property, which produces income of $100,000, is capitalised at 6.0% – the market value would be $1,666,666.
If, due to market forces, the capitalisation rate tightened to 5.0%, and the income remained the same, the market value of the property would increase as per example 2.
Example 3 demonstrates if the capitalisation rate rose to 7.0%, and the income remained the same, the capitalised value would decrease.
As you can see, market value moves inversely from capitalisation rates.
Once an asset value is determined, valuers can adjust for certain variables.
For instance, the valuers would make an adjustment for how much the current tenants are paying, compared to what the market rent of that property should be. Likewise, there would be adjustments made for any discount or tenant incentives that a building owner is applying to that space for the duration of those tenants’ leases.
As part of this approach, valuers also look forward over the immediate horizon – which might be anywhere between 12 and 36 months – to consider any near-term lease expiry and will make an adjustment to reflect the costs associated with that downtime and re-leasing. They will examine whether there is any vacant space, as well as the costs associated with leasing that space out.
Valuers also look at any capital expenditure (capex) considerations that there might be. For example, if there’s a broken lift, and it’s estimated that $5 million will be required for a replacement, adjustments will be made to the core value, to end up with the market value. That value is applied to a point in time – “as at” the day of valuation.
Discounted cash flow approach (DCF)
More assumptions are involved in a DCF when compared to the income capitalisation approach – including the target return or discount rate, rental growth, lease expiry allowances, renewal probability, capital expenditure, and a hypothetical sale profit– but it has the potential to provide a more accurate picture of the cash flow horizon over a longer period.
Using this method, valuers typically forecast a 10-year cash flow, with a hypothetical sale profit at the end of year 10. All the income over 10 years is discounted back to a present-day value at an appropriate discount rate. An exit terminal value at year 10 (for the hypothetical sale, using an appropriate terminal yield) is also discounted to a present-day value. To derive the net present value of the property, it becomes the sum of the discounted property cash flows and the discounted terminal value.
Determining an appropriate discount rate
To determine an appropriate discount rate, a comparison is made with returns from alternative investments, the most common comparison being the 10-year government bond rate, as it is considered ‘risk-free’ and matches the investment horizon. A premium is then applied to reflect the risk of a property investment when compared to the ‘risk-free’ rate.
Adjustments
Adjustments are made within the 10-year cashflow. For example, consider a multi-tenanted building. Realistically, not all tenants are going be there for the entirety of that 10-year horizon – so, these lease expiries are factored into existing lease cash flows.
The valuer considers what happens when each tenant’s lease expires, applying a renewal probability of that tenant remaining (or leaving) and applying associated costs for potential downtime, capex to refurbish the space and the costs associated with re-leasing (leasing fees, incentives, etc.).
If an expiry is in six years, for example, the valuer has an informed opinion of what the market rental should be as at today, and then they’ll apply a growth rate to get to the market rent at that point in time. They’ll also apply a tenant incentive and will have a hypothetical lease term at that point in time.
So, the valuer is making a lot more assumptions here than what they would do in a capitalisation approach – but they’re also getting a longer horizon of cashflows to look at.
The two biggest contributors to determining a property’s value are: a) the net market income it can deliver; and b) the appropriate rate of return. An appropriate rate of return is the appropriate “multiple” or risk premium to apply to the income (like price-earnings) considering asset and market-level risk factors.
Both the net market income and the rate of return are affected by property and market-level considerations.
Property characteristics
There are all kinds of property characteristics that contribute to determining an asset’s value. This includes the physical and locational characteristics of the land itself – for instance, an office building in the middle of the Sydney CBD is going to be worth more than that exact same building and lease profile in a metropolitan or regional market.
There are several additional factors that are important, including access to transport, amenity, natural light, and physical characteristics of the building. The desirability of the building for tenants is important to consider – for example, in a residential context, properties on Sydney Harbour or Brisbane River are worth more than those away from the waterfront. For commercial property tenants, proximity to customers and suppliers is also important, as are end-of-trip facilities; operational efficiency/sustainability; design and ambience; and floorplate layout.
And then there is the tenant occupied characteristic – is a leased building worth more than an unleased building or a vacant building? Usually, the answer is that the leased asset has a higher value. Other factors, including weighted average lease expiry (WALE) are factored into the valuation – longer WALE is usually valued more highly, due to the security of the income and lack of capital expenditure (capex)/downtime assumptions. Spaces occupied by blue-chip tenants and government departments are generally valued more highly, due to the security underpinning the lease.
Similarly, costs associated with the property also come into consideration – a building that requires a heavy amount of capex is generally going to be worth less than a building that’s just had a large amount of capex spent on it.
Market conditions
Broader market conditions also play an important role in determining asset values at a point in time. As explained above, movement in the ‘risk-free’ rate influences the appropriate risk premium to be applied to a property’s cashflow, and is affected by interest rates, inflation, and other financial and economic conditions.
Surging inflation and higher interest rates have been a major driver of recent cap rate movements, with the cash rate target increasing by 4.25% since March 2022, and the 10-year government bond yield increasing by 1.69% over the same period. This has led to a similar rise in cap rates, in order to maintain the typical ‘spread’ between the risk-free rate and property. The table below highlights the shift using New South Wales/Sydney as an example.
| Property Avg Equivalent Yield | Prime CBD Office | Outer Central West Sydney Industrial | NSW Regional Shopping Centres | NSW N’hood Shopping Centres | 10y Gov Bond Yield |
| Mar-22 (%) | 4.44 | 3.26 | 5.13 | 5.13 | 2.50 |
| Dec-23 (%) | 5.69 | 5.25 | 6.00 | 6.25 | 4.19 |
| Change (bps) | 125 | 200 | 87 | 113 | 169 |
| Spread to Gov Bond (bps) | 150 | 106 | 181 | 206 | na |
| Historical (25y) Avg Spread (bps) | 184 | 310 | 200 | 340 | na |
Uncertainty regarding the future can also be an influence on cap rates. This has been exemplified by office valuations, where the impacts of hybrid working on office space demand are yet to be fully understood. While some of the potential impacts may be reflected in rental growth assumptions, some may be reflected in the cap rate as a general measure of higher risk.
Capital markets can also influence cap rates. If a particular asset class or sector becomes more desired, the price investors are willing to pay per unit of income will increase and vice versa. This was seen over the last five years across the industrial sector. Institutional investors in particular viewed the sector more favourably than had been the case historically, contributing to a greater weight of capital pursuing an allocation – the magnitude of the capital shift outpaced the ability of the market to supply new stock, leading to higher valuations.
In the face of fluctuating markets, a commercial property valuation is the most reliable way of determining the representative value of Cromwell’s income-producing assets. As a business, we adhere very closely to the methods outlined above to provide investors with clear and accurate information on each of our assets. Cromwell will continue to provide transparency about the valuation process – and how our properties are valued, as the information is generated.
Property real estate income funds can be an attractive investment for those people seeking a reliable source of regular income. Most of this income comes from rent earned on the fund’s underlying properties and, as rent is usually paid monthly, a property fund is able to pay distributions monthly or quarterly, which is an advantage for an investor’s personal cash flow. At times, some of the income from property funds may include a component of “tax-deferred distributions”.
Due to their complexity, however, tax-deferred distributions are rarely understood by anyone outside professional investor or tax specialist circles.
Tax-deferred distributions occur when a fund’s cash distributable income is higher than its net taxable income. This difference arises due to the trust’s ability to claim tax deductions for certain items – such as tax decline in value on plant and equipment; capital allowances on the building structure; interest and costs during construction or refurbishment periods; and the tax amortisation of the costs of raising equity.
In tax technical terms, tax-deferred amounts can give rise to distributions from property trusts of “other non-attributable amounts” for trusts that have elected to be Attribution Managed Investment Trusts (AMITs) and “tax deferred” components in non-AMITs – all referred to as tax-deferred distributions in this article.
Tax-deferred distributions are generally non-taxable when received by investors. Instead, these amounts are applied as a reduction to the tax cost base of the investor’s investment in the property fund, which is relevant when calculating any Capital Gains Tax (CGT) liability upon disposal of the investment units or once the tax cost base has been reduced to nil. Therefore, any tax liability in relation to these amounts is ‘deferred’, typically until the sale or redemption of an investor’s units in the fund when CGT may arise.
At its simplest, tax deferral works as follows: suppose a trust earns rental income of $100 and has building allowance deductions of $20. Then the net taxable income is $80, which is distributed to unitholders to be included in their taxable income. The remaining $20 of cash is distributed to the unitholders too, but for tax purposes it is regarded as a reduction in cost base of the units invested in the fund by the unitholder.
So long as the accumulated tax-deferred income is less than the investor’s acquisition cost, the tax is generally able to be deferred. If tax-deferred amounts have reduced the cost base to zero – that is, if the investor has received total tax-deferred distributions at least equal to the original cost of the investment – then any excess must be declared as a capital gain in the year it is received.
Capital gains are distributed by a trust only when the trust sells capital assets at a tax profit. These gains are then subject to tax in the investor’s hands, the same as other gains. Alternatively, investors are taxed on any capital gains, including any accumulated tax-deferred distributions, when they dispose of their units in a trust or the trust is wound up.
An incidental benefit of tax-deferred distributions for investors is the ‘deferral’ of tax until a CGT event, such as when the sale of your units or the wind-up of the trust, triggers a CGT liability.
Tax-deferred distributions reduce the investor’s cost base for CGT purposes, thereby increasing the CGT gain upon realisation. If the investor holds the units for more than twelve months, they may be able to significantly reduce the tax payable by applying the 50% discount for individuals, or by the one-third discount for superannuation funds.
Tax-deferred distributions may also be reinvested until such time as a CGT event occurs. The compounding benefit from reinvesting these distributions can be significant over time.
The case study below shows the effect of tax-deferred distributions for an investor on the top marginal tax rate (assumed to be 45%). The case study compares a hypothetical $100,000 investment into an interest-paying investment earning 5% per annum with a property investment paying 5% distributions.
As you can see, an investor on a marginal tax rate of 45% and entitled to a 50% CGT discount makes a tax saving of $3,375.
Assumptions used in the case study:
1. Capital gain = $100,000 capital redemption, less reduced cost base of $85,000 ($100,000 initial investment less $15,000 tax-deferred distributions = $85,000) = $15,000 capital gain. Tax payable = $15,000 x 45% x 50% = $3,375. The tax payable does not take into consideration any Medicare Levy surcharge.
This article has been prepared by Cromwell Funds Management Limited ABN 63 114 782 777 AFSL 333214 (CFM). The above information has been prepared for general information only and should not be relied upon as tax advice. This information should be read in conjunction with the Australian Taxation Office’s (ATO) instructions and publications. An investment in a property fund can give rise to complex tax issues and each investor’s particular circumstances will be different. As such we recommend, before taking any action based on this article, that you consult your professional tax adviser for specific advice in relation to the tax implications. This document does not constitute financial product or investment advice, and in particular, it is not intended to influence you in making decisions in relation to financial products. While every effort is made to provide accurate and complete information, Cromwell Property Group does not warrant or represent that this information is free of errors or omissions or is suitable for your intended use and personal circumstances. Subject to any terms implied by law which cannot be excluded, Cromwell Property Group accepts no responsibility for any loss, damage, cost or expense (whether direct or indirect) incurred by you as a result of any error, omission or misrepresentation in the information provided.
Read more about Cromwell Direct Property Fund, including where to locate the product disclosure statement (PDS) and target market determination (TMD). Investors should consider the PDS in deciding whether to acquire, or to continue to hold units in the Fund.
Australians’ love affair with, and focus on, residential property means that a whopping 68% of the average household’s total wealth is allocated to this one asset type1. Most investors will understand this lack of diversification increases risk and introduces volatility.
The defensive characteristics of property, however, are still very much in demand from yield-hungry investors and one option available to them is to consider commercial property as an alternative to their residential investments.
Security of income from commercial property is generally higher than residential property due to the binding nature and longer term of commercial leases. Additionally, commercial tenants’ financial covenants are often superior. Commercial tenants are also often responsible for the majority of outgoing expenses whereas residential tenants are not, providing investors in commercial property with a higher percentage of rent received.
According to CoreLogic2, average rental yields for houses in Australian capital cities fell to a record low of just 3.1% in 2016, compared to commercial property yields of 6.3% for the year to 31 December 20163. Both types of property offer the potential for capital growth.
Like all investments, there are risks and traps associated with commercial property, and investors need to understand the characteristics of the asset class before committing.
Commercial property refers to all non-residential real estate and is divided into three main sub-classes – office, retail and industrial.
Table 1: Features and General Return Profile of sub classes
| Office | Retail | Industrial | |
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| General return profile |
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In general terms, investors have two options – they can buy a property directly themselves, or pool their money with others.
Direct investment can definitely pay big dividends – many a family fortune has been founded on the back of astute accumulation of commercial property, but for the majority of individual investors, buying and managing a commercial property is neither possible nor sensible. The high cost of most commercial property makes it financially out of reach, and maximising returns from a commercial property requires serious skill and expertise, which individual investors may not have.
Direct commercial property investment within an investor’s SMSF is becoming more common, in particular where members own commercial premises and look to transfer them into their fund. There are, however, barriers to this in the form of SMSF borrowing and contribution caps legislation, and it could also be considered questionable in terms of diversification where a person’s income and superannuation fund both rely on the one place of business.
1. Listed property (A-REITs) investment – property, in a liquid form
A-REITs were discussed in detail in our last issue, and the characteristics are examined briefly again as follows:
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2. Unlisted property – trading liquidity for a more direct property exposure
Unlisted property trusts are also known as property funds, syndicates, or schemes. They allow investors to buy units in a professionally managed trust which directly holds investment property or properties. Unlisted property trusts can be closed-end (fixed duration of usually 5-7 years) or open-end (no set duration with limited liquidity throughout).
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Commercial property investment has historically delivered attractive risk adjusted returns with an average (annualised) total return (inclusive of income and growth) of 11.0% over the last five years, 8.9% over the last ten years, and 10.5% over 15 years, up to December 2016, according to the MSCI All Property Universe Index (which is published by MSCI’s analysis of over 1,440 Australian commercial properties)3.
Whether purchasing commercial property directly or by pooling your funds with others and investing into REITs or unlisted property trusts, the benefits of investing into commercial property certainly should be considered within a diversified portfolio.
1. Australian Bureau of Statistics (ABS), Australian National Accounts: Finance and Wealth, September 2016, Release 5232.0
2. CoreLogic Hedonic Home Value Index, December 2016
3. MSCI IPD All Australian Property Index December 2016
In a low interest rate environment, commercial property continues to offer attractive opportunities for income-hungry investors. But what drives commercial property yields? How do they impact asset prices? And how are they affected by changes in interest rates and bond markets?
For investors seeking a reliable income stream, commercial property can offer very attractive opportunities; especially at a time when bonds and fixed income rates are at record lows.
In our article, Understanding the Commercial Property Market (Insight, Autumn 2017), we compared residential property yields with those of commercial property. The one year results favoured commercial property, with a yield of 6.3% in the year to 31 December 20161, in comparison with average residential property rental yields hitting new lows of just 3.1% in Australian capital cities over the same time frame2. As further comparison, Australian shares currently offer an average yield of around 4.2%3.
So, while commercial property yields have moderated along with other investment returns as interest rates have fallen, the sector still remains a leader on yield. This isn’t simply a coincidence. In many ways, yield is the key to the commercial property market, driving both investor behaviour and asset prices.
Yields, prices and cap rates
In the residential property market, price often drives yields, rather than the other way around. Spurred on by sentiment or the hope of capital gains, residential property buyers have recently bid up the price of housing to exceptional levels, even while rents have remained relatively static.
As a result, residential rental yields have fallen dramatically, to levels well below those offered by other asset classes. Despite today’s low interest rate environment, many residential property investments now generate yields lower than the cost of borrowing, leaving investors with a potential loss, unless they can later sell at a high enough price to recover their costs (the strategy known as negative gearing).
In contrast, negative gearing is not a strategy pursued by commercial property investors. Not only do commercial property investors generally seek higher yields to cover their cost of debt, they typically value properties based on the rental income they can generate — similar to valuing a business on a multiple of profit.
A key concept here is the capitalisation rate or cap rate. Calculated by dividing a property’s net rental income by its value, cap rates are widely used to assess and compare potential commercial property investments. As a result, the value of a property often depends on the yield that investors are willing to accept.
Let’s look at an example to see how it works:
Imagine an investor owns a building valued at $10 million which generates a net income of $700,000 per year.
As a result, the building’s cap rate is: $700,000 ÷ $10,000,000 = 7%.
Now suppose that the same investor has the opportunity to buy a second building, which generates a net income of $1 million a year. How much should they be willing to pay for it?
Assuming they want to achieve the same 7% cap rate as their first investment, they would value the new building at:
$1,000,000 ÷ 7% = $14.28m.
But if they were willing to receive a cap rate of only 5%, they would be willing to pay more – up to
$20 million ($1,000,000 ÷ 5%).
That’s important, because investors don’t make decisions about yields in isolation. Instead, they are influenced by a range of factors, particularly changes in interest rate settings and the yield offered by other investments, especially bonds. Which is why changes in interest rates and bond yields can impact commercial property prices so strongly.
1. MSCI IPD All Australian Property Index, December 2016.
2. CoreLogic Hedonic Home Value Index, December 2016.
3. ASX/S&P ASX200 dividend yield as at 12 May 2017. Source: Morningstar.
Inflation can be detrimental to an investor as it chips away at savings and investment returns. Where inflation picks up, investors often turn to real assets such as real estate as a hedging strategy. Here, we outline a number of ways in which commercial property can act as a hedge to inflation.
Value increase for existing stock
An upside for investors is that inflation can lead to an increase in property values.
Rising inflation can lead to an increase in the cost of building materials for developments in one of two ways. First, should interest rates rise, it would lead to higher borrowing costs and resultingly, increases in the cost of building materials for developments.
Second, and most relevant in the current environment, supply constraints have made access to building material increasingly scarce, thereby driving prices up.
Both of these factors lead to new construction becoming increasingly less attractive or viable. As a result, this can limit the supply pipeline and increase the price for existing properties.
Value-add office strategies an alternative to new builds
According to JLL, demand and occupancy throughout the pandemic of modern, quality office stock has outperformed the market as COVID-19 has heightened awareness of health, safety and sustainability. As construction of new stock is strained, this will likely result in an uptick in value-add strategies to redevelop or retrofit older stock with a particular focus on occupant wellness.
Lease structure
Commercial property leases can include fixed annual rental increases, giving investors an income boost that offsets the effects of higher inflation. It is common for annual rent increases to be set above the long-term inflationary outlook, or even specifically tied to increases in inflation.
For example, a long-term lease to a government tenant in an office building might have annual rent increases structured at a fixed rate plus CPI inflation. For quality, well-located stock in an environment with heightened demand due to less stock coming to market, landlords are in a position to charge higher rent.
The downside is that if inflation is too high, it is harder for investors to capture rental growth at or above inflation, resulting in a hit to income streams.
Where are investors looking?
According to JLL, investment into commercial real estate across the Asia Pacific region is tipped to increase by 15% in 2022, after a 30% increase in 2021. As economic activity stabilises, travel restrictions continue to lift and employees return to cities, office investment is tipped to increase by between 20% and 30% this year.
Higher quality assets with lower levels of vacancy, often leased on long-term deals to government, listed and blue-chip tenants will continue to curry favour with investors due to their ability to provide access to regular, reliable income through market ups and downs.
