Scott Keck

Buying a shop offers property investors a useful diversification away from residential, but they should check carefully before committing themselves.

Strip retail: Strong demand but care required

Retail property, typically a shop in an inner-suburban, well-established retail strip, has become the strongest focus of many property investors.

Representing the next stage of diversification from residential, but not requiring the greater expense of bigger industrial or commercial properties, retail properties priced between $500,000 and $2 million are favoured for their reliability, simplicity, low obsolescence, and high land value component.

With the current weight of investment funds available, and the attraction of being able to include commercial property in self-managed superannuation funds, retail properties particularly have become more sought-after and relatively more expensive – typically compressing yields on prime property by 200 basis points over the past three years, from 7% down to 5%.

The premiums being paid raise questions about whether there will be sufficient growth and recovery of net income and acceptability of yield movement to ensure such investments perform; or, alternatively whether are heading for a cyclical peak after which acceptable returns will be elusive. For investors, there are three distinct issues about which caution and analysis are required.

First, under the new legal regime for the governance of retail tenancies, land tax is no longer recoverable. It seems that many landlords and potential investors still grossly underestimate the impact of this change, particularly the extent to which land tax may increase and undermine real net return.

Second, there is an increasing economic acceptance that retail sales may slow, which would reduce retailers’ operating margins and make them more resistant to rent increases.

Third, although the outlook is stable, interest rates will increase in the medium term and, inevitably, property yields will follow. If all three were to occur, a $1 million property currently returning $50,000 a year at a 5% yield could over 18 months revert to a $48,000 income at 5.25% yield, reducing the capital value to $915,000.

The best strategy to avoid a retail value decline is by a thorough analysis of income and outgoings, particularly land tax movements, and to select properties where growth and income are attributable to population growth and demographic change, rather than just for inflationary reasons.

This suggests investors should look at well located but “secondary” properties that are yet to come into their best period, as locational influences and urban regentrification have their benefits.

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