It represents an important asset class within a diversified portfolio framework because it provides investors with a relatively stable source of income via regular distributions or rents while providing low correlation to other asset classes such as shares and cash. In addition, real estate values and income should keep pace with inflation and can help maintain real returns.
From an investor’s viewpoint, property can be broadly split into the following groups: commercial (shopping centres, offices), industrial (factories, warehouses, storage), and residential (houses and apartments). It can also be directly owned, like most residential houses, or indirectly owned through a managed fund or a real estate investment trust.
Types of Investments
Investors buy the physical asset outright and are responsible for the maintenance, rental agreements and tax implications of owning the property. With appraisal valuations completed annually, direct property may provide less volatile returns than listed property. Much of direct property investment lies in the residential space because it is more affordable to the majority of retail investors. However, the key issue with direct property investment is that it can incur considerable liquidity constraints and transaction costs.
Investors hold shares in a fund or trust which uses the proceeds to invest in a portfolio of real estate assets. This type of investment provides investors with wider diversification benefits than direct property because the funds usually invest in a variety of larger real estate holdings in commercial and industrial assets. Similar to shares, listed property tends to be liquid investments but is subject to daily share price fluctuations. Currently, listed real estate represents about 8% of the Australian sharemarket.
There are diversification benefits for investors wishing to invest outside of the domestic space, however one needs to be mindful that returns can be significantly influenced by currency fluctuations. Returns from domestic and global Real Estate Investment Trusts (REITs) tend to be similar in the long term, however domestic REITs usually exhibit a higher income component then its global counterparts. Historically, there is a low correlation between listed REITs in Australia with those in other countries around the world. Fortunately, exposure to the global property market can be obtained via Australian Listed Property Trusts (LPTs) that invest in overseas geographies such as the Westfield Corporation.
The key risks of property investing include the cyclical nature of real estate valuations, vacancies, increased competition, overdevelopment, rising interest costs, occupancy rates, and regulatory changes.
From a portfolio construction perspective, property falls within the category of “growth” assets. Growth assets tend to carry greater risk but have the potential to deliver higher returns over the long term. The chart to the right shows the approximate risk-return profile for property in contrast to the other asset classes. On the risk-return curve, property sits between fixed income and shares.
The chart titled “Asset Class Performance 10 Years to 31 December 2015 (%pa),” displays the gross return of various asset classes over the last decade to December 2015. Not surprisingly, returns on direct property have outperformed listed REITs and shares due to a combination of structural and cyclical factors facing Australia, including rising migration and population demographics, years of government underinvestment and limited supply and access to cheaper funding. In the current environment of low inflation and subdued interest rates, investors tend to favour growth assets, like property and infrastructure, to take advantage of the low cost of debt and to compensate investors for the lack of income generated by cash and fixed interest investments. However, investors need to be wary that the historically strong return achieved from residential property is unlikely to be repeated as more domestic supply comes on stream.
Asset Class Performance 10 Years to 31 December 2015 (%pa)
Note: This article is intended to provide general advice only, and has been prepared without taking account of your objectives, financial situation or needs, and therefore before acting on advice contained in this document you should consider its appropriateness having regard to your objectives, financial situation and needs. If any advice in this document relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement for that product before making any decision.