What ‘Property for Income’ Really Means
When making an investment, it’s vital to determine how it will fit into your portfolio and whether it meets the strategy and objectives you set for it.
Establishing the relative exposure between growth and income investments is especially important. Traditionally, the capital value of growth assets like equities and property (residential and commercial) can fluctuate substantially over time. Such assets typically deliver most of their returns from capital gains.
In contrast, income investments like cash, fixed interest, and, to a lesser extent, infrastructure assets like roads and utilities, rely heavily on income for their total return. There is therefore a correspondingly limited opportunity for capital growth.
In investment, volatility and risk walk hand in hand. In constructing an investment portfolio, those wanting less volatility and a regular income stream will therefore primarily invest in income assets because growth assets carry higher levels of risk and volatility.
The real challenge is in identifying the level of risk in an investment. I have found the simplest way to think of relative risk is by examining the cash flow of a hypothetical company, as shown in table 1.
The table shows four of the major investment asset classes represented:
1. Rent on premises goes to the landlord that owns the commercial property leased by the company;
2. Interest on borrowings goes to bondholders or banks that hold the debt;
3. Cost of utilities goes to the owners of the infrastructure assets;
4. Cash available to shareholders goes to the equity holders in the business.
It’s important to understand that the first three asset owners - commercial property, fixed interest, and infrastructure - are ahead of the shareholders in accessing the cash flow from our hypothetical business.
Shareholders receive the surplus cash only after the other three asset owners have been paid their due. If surplus cash has been exhausted by paying these other interests first, shareholders get nothing. That is the equity risk.
From a risk perspective, being at the front of the queue for business cash flows is preferable to being at the back of it.
But this isn’t the whole picture. Investment is about balancing risk and return. Over the long term, markets will pay more for lower-risk assets and less for higher-risk assets. This means that assets that are priced highly will, over the longer term, return less and those that are priced lower will return more.
Because of the higher level of risk, equities are generally priced lower by the market, resulting in higher, longer-term returns for investors. In addition, shareholders also benefit from leverage. A small increase in sales or a small decrease in expenses delivers a correspondingly higher proportional increase in surplus cash flows available to them.
Asset classes that receive preferential cash flow could therefore be identified as income assets while those that receive lower priority, like shareholders, as growth assets.
The landlord as banker
Landlords and bankers stand near the top of the queue for access to the cash generated by a business, although bankers usually find a way of elbowing their way in front!
The landlord is a lender of property and a bank a lender of cash. The landlord receives consideration (fee) for the loan of property as rent just as the banker receives interest for the cash it lends.
The respective loan terms also have similarities; the landlord’s established via a lease while the bank has a loan agreement with the lender. At the end of the loan term, the borrower must repay the loan principal to the banker and return vacant possession of the property to the landlord.
But there’s one vital difference. When a bank lends, say, $100,000, it receives this principal as cash at the end of the loan term. There is no argument about how much $100,000 is worth to a banker, or anyone else.
In contrast, the value of the property returned at the end of the lease (called a reversion), and the rent the landlord can expect to receive from the next tenant, is determined by the market. The quality of the building, demand and supply, location, utility, and general economic circumstances all feed into the value calculation made by potential tenants.
It is this uncertainty (risk) that makes commercial property a fundamentally different asset class to fixed interest.
The importance of the lease
But this doesn’t make commercial property more of a growth rather than an income asset. Whilst company profits tend to fluctuate with the economic environment (and share prices are influenced by how investors value those profits) the landlord’s situation is quite different.
A corporate tenant may endure wildly fluctuating profitability over the course of its lease, the effects of which will be felt by shareholders. The landlord, however, is protected by being near the front of the queue for access to the cash generated by the tenant and the legal obligation of the tenant to pay rent, as defined by the lease.
The lease requires the tenant to pay a fixed amount of rent for a predetermined amount of time. It may also allow for rent reviews, either to a certain fixed percentage, to CPI (inflation), or to market (whatever is being paid for similar properties). In almost all cases in Australia, rents can only rise, no matter the circumstances of the tenant.
“In investment, volatility and risk walk hand in hand!”
Assuming a tenant remains solvent, the landlord will receive rent that is at least, if not more, than the first year’s rent paid by the tenant during the period of a lease. The landlord is therefore insulated from the fluctuating business conditions of the tenant and the business cycle. The only occasion where the landlord is exposed to the open market or the business cycle is when the lease expires.
These factors reduce the investment risk substantially, making commercial property more of an income than a growth asset.
The Property for Income philosophy
The phrase ‘Property for Income’ is used a lot. In fact, it’s fundamental to the way we at APN manage our property investments, based on four principles that ensure we remain tightly focused on security and stability of income at lower-than-market risk;
1. We recognize that leases and the rents they generate are a fundamental characteristic of commercial real estate;
2. We avoid property investments that are more equity-like in nature, typically where significant proportions of revenue originate from non-rental sources;
3. We seek out investments with longer-than-average leases, and;
4. We select investments that have long term utility, reducing the potential impact of lease reversion.
By sticking to these principles we provide investment products that can closely replicate the risk and return of traditional income assets, making our investments in commercial property truly Property for Income.
Howard Benchley, Founder of APN Funds Management