The news is mostly bad for commercial property investors

05/23/23 • 18 min

All investment asset classes move in cycles. Investment returns are almost never linear. As such, investors must expect good and bad periods, which is why patience and discipline are big contributors to an investor’s success.

I suspect that commercial property investors’ patience and discipline are about to be tested. This asset class is facing a lot of challenges. However, as they say, every cloud has a silver lining so there could be good investment opportunities over the coming months and years.

What challenges is commercial property facing?

Commercial property was the asset class that was the most adversely impacted by Covid lockdowns, especially the retail and office sectors.

Commercial property landlords had to provide rent waivers and reductions to retail tenants to help them through lockdown periods. But, unfortunately, not all retail businesses survived which increased vacancy rates.

Employees were also encouraged to work from home for long periods of time. This experience demonstrated that people did not necessarily need to be in the office full-time. As such, most of the office workforce has adopted a hybrid work model that involves working from home 2 to 3 days per week. The consequence of this is that large employers have reduced their commercial office footprint. In addition, businesses have been less inclined to commit to new leases until they can ascertain what long-term working arrangements may look like.

The upshot of this is that tenant demand for office and retail property is very low at the moment.

That said, things are changing - albeit slowly. More employers are demanding that their workforce spend more time in the office. nab is probably the largest corporate leading this charge demanding all senior managers work from the office 5-days per week. I expect other large corporates to follow, especially if the unemployment rate normalises (it’s currently 3.5% - the normal level is circa 5%).

But the real problem is cap rates!

Cap rates is an abbreviated term for capitalisation rate. It is the key component used to value commercial property. Unlike residential property, the value of a commercial property is dependent on the rental income that a property generates (whereas residential property is driven more by the value of the underlying land).

Therefore, to value a commercial property, you must apply a cap rate to its income. Th

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What challenges is commercial property facing?

Commercial property was the asset class that was the most adversely impacted by Covid lockdowns, especially the retail and office sectors.

The upshot of this is that tenant demand for office and retail property is very low at the moment.

But the real problem is cap rates!

Therefore, to value a commercial property, you must apply a cap rate to its income. Th

Previous Episode

What is more tax-effective, investing in property or shares?

Many people are attracted to borrowing to invest in property because of negative gearing tax benefits. That is, the (income) loss that an investment property generates helps reduce the amount of tax you pay on your salary or business income.

However, investing in shares also offers unique tax advantages.

I thought it would be interesting to quantify and compare the taxation outcomes of these two investment options.

Taxation of share market investments

Investing in shares can result in some attractive tax outcomes.

Tax credits

Australia’s imputation system, which was introduced by the Hawke-Keating government in 1987, is unique to Australia. It seeks to avoid the double taxation of corporate profits. It does that by giving shareholders a credit (called franking credit) for the tax that the company has paid.

For example, if a listed company makes a net profit of $100, it will pay tax at the flat rate of 30%, so its profit after tax is $70. If it pays the profit out as a dividend to shareholders, the shareholders will receive $70 in cash and a franking credit of $30.

Therefore, if the shareholder has no other taxable income, when they lodge their personal tax return, the $30 franking credits will be refunded, meaning that shareholder has received $100 in total (being $70 dividend plus $30 tax refund).

Therefore, investing in Australian shares which pay franked dividends is particularly attractive to taxpayers that have low tax rates such as super funds, family trusts that have adult beneficiaries with low taxable incomes, and so forth.

Even if you are on the highest marginal income tax rate, you are only going to pay 17% of tax on (fully franked) dividend income, because the company has already paid 30%.

If you invest in international shares, and Australia has a tax treaty with the country where the shares are listed, you may be able to claim a foreign income tax offset for the tax that you have been deemed to pay in that country. Although, these credits are not nearly as generous as the Australian imputation system.

CGT

Capital gains tax applies to share investments. If you hold shares for more than 12 months, you will be entitled to the 50% CGT discount, which means only half of the net capital gain will be included in your taxable income.

As a rule of thumb, you can calculate yo

Next Episode

Does household income drive property prices?

Commentators often refer to the price of property relative to household incomes. For example, it is estimated that property in Melbourne and Sydney now costs more than 10 times the median household income.

But is this really a meaningful measure because if it is, property cannot continue to grow at a faster rate than incomes (a point often made).

If prices continue to rise faster than income, how will property be affordable?

At the beginning of this year, I wrote about the factors that have driven property prices higher over the past four decades. I concluded that borrowing capacity together with higher incomes have increased 3.5x since 1980, whereas property prices have increased 4.5x. That is, prices have grown faster than incomes and borrowing capacity growth combined. Clearly, something else has contributed to property growth for it to be affordable for some buyers.

It is worth stating at this point that borrowing capacity is likely to be flat in the future. That is, borrowing capacity will not increase anywhere near it has over the past four decades. That will probably have an adverse effect on property price growth in many locations.

Do locations with higher incomes perform better?

Data analyst, Jeremy Sheppard has done some work on this question and found there’s a weak statistical relationship between income and capital growth rates. The thesis is that people that earn more can afford to pay more for property. Therefore, we should invest in locations that have above average household incomes. A big problem with Jeremy’s analysis is that the data may not be accurate and/or out of date (which Jeremy acknowledges), so this thesis is impossible to test.

I think the reality is that incomes do have an impact, but so do many other factors, so it is impossible to isolate the impact of income alone. Also, do you really need census data to identify the locations that wealthy people want to live in? I think those locations are pretty obvious.

What other factors may be pushing property prices higher?

Approximately, one-third of Australians own their home without a mortgage, one-third own their home with a mortgage and one-third rent. That means that approximately two-thirds of Australians’ (owner-occupier) property decisions are driven by lifestyle goals. Of course, people will draw on financial resources other