Institutions: why not residential?

August 17, 2016 / By  

Residential property has long been seen as a staple investment for individual retail investors within Australia. Favourable tax structures and relatively consistent capital value growth and rental returns (at least within most capital cities) have delivered strong investment returns to tens of thousands of Australians. However, unlike many other established property markets (e.g. United Kingdom, United States and Germany) institutional investors have not invested in residential property outside the traditional residential development framework of selling freehold titles to individual purchasers.

Globally, the asset class of Multi-Family property is quickly establishing itself as an alternative asset class alongside the increasingly competitive commercial property sector. Unlike traditional residential apartment investments which are sold off as an individual freehold title, Multi-Family investments retain the ownership of the entire complex (or residential community). Just like a traditional commercial property investment, returns are derived from the rental income of the entire building.

In Australia, institutional investors have generally avoided residential property due to its comparatively poor long-term returns (Brisbane 10-year average unit yield is 4.87%, compared to 7.09% for a core CBD office investment), rigorous and costly asset management requirements, inferior liquidity and limited large scale opportunities. A major factor that has restricted the implementation of a Multi-Family investment platform in Australia has also been the ownership structure of the rental market.

Unlike established Multi-family markets such as the US, all large-format residential projects are sold off as individual units to retail investors. This structural difference has been largely the result of investment friendly tax mechanisms such as negative-gearing and favourable capital gains tax (CGT) rates. Negative gearing is a tax mechanism that allows investors in residential real estate to claim mortgage interest costs for tax purposes as a deduction against the rental income derived from that asset.  Property owners can claim the subsequent tax loss against their personal income, reducing their tax liability. Combined with low rates of CGT, rental yields have been driven down by investors seeking to take profits through capital gains, not rental income.

Although the residential rental market is currently dominated by small private investors, increasing affordability issues across capital cities have the potential to create a ‘generation of renters’. This cultural shift may open the door for large-scale institutional investments if renting is to become a lifelong option, and rental returns increase on the back of increased tenant demand. If such an opportunity does arise, it will provide institutional investors with the opportunity to realise efficiencies through economies of scale, similar to commercial portfolios.

The current market fundamentals of Australian residential markets do not satisfy the requirements for institutional investors, but this does not mean it will be the case forever. Changing demographic trends, decreasing affordability in Australia’s capitals and lower hurdle rates for investors in this low interest rate environment may one day open the door for Multi-Family investment vehicles in Australia.

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