Britain is a nation of property lovers. The question is: have you ever thought about buying part of the local high street by investing in commercial property, rather than the traditional residential property?
The asset class hasn’t always been plain sailing. In the year 2008, commercial property prices fell by an extraordinary 44 per cent almost overnight as the US subprime mortgage catastrophe resonated around the globe.
The market has recently recovered, however property prices are still around 30 per cent lower than they were at their peak in 2007. The ongoing market instability and uncertainty about the global economy has raised significant interest in the commercial property sector, as investors look for secure investments.
The fundamentals
The commercial property market is made up of offices, shops and industrial buildings, such as warehouses.
Investment funds then purchase these units and rent them out to other companies on long leases, thus making a profit from the income received from renting such properties as well as the growth in capital in the price of the property.
The commercial property sector traditionally has little correlation with equities and bonds; therefore in times of instability, commercial property can preserve wealth. It is popular with income seekers, as it pays a regular return in line with rental payments.
The sector has reaped interest among investors as it’s tangible. Guy Glover, fund manager at F&C Reit Asset Management says, “It’s a real asset; something investors can touch and feel”.
Since 2007, the market has slowly but surely got itself back on its feet, and is fast becoming a healthy investment again.
David Paine, head of real estate at Standard Life Investments, regards global commercial property as an ‘attractive component’ of a ‘diversified, multi-asset portfolio.’
He further adds: “Good quality commercial property is likely to remain resilient despite the global economic slowdown, which we expect to result in a period of weak growth rather than outright recession.”
Investing
There are a number of ways to invest in commercial property, either directly or indirectly. Investing indirectly through a fund or trust, which will invest in a range of different properties, is a simple and less risky way to access the sector.
Gordon Kearney, Investment Director of Colchester-based Fiducia Wealth, says “For most investors, the most appropriate way to invest in commercial property is via a collective investment scheme like a fund or trust.” He further adds, “Property funds on the whole are cheap and easy way to gain exposure to commercial property as an asset class.”
Investment funds and trusts providing exposure to the sector are divided into two types. A traditional bricks and mortar fund and a property securities fund. The former will see investment in the property directly, and be structured as either an open-ended fund or a closed-end investment trust. Those buying the property will be responsible for its maintenance and rent collection, and have the added benefit of a regular income. The property securities fund will invest in the shares of property companies.
However, as offices and warehouses are not easily bought or sold, the funds cannot be readily convertible into cash.
On the other hand, a property securities fund invests in listed property companies and is far more liquid; however it is subject to the ups and downs of the stock market.
Financiers can also buy shares directly in a Real Estate Investment Trust (REIT) such as Land Securities (LAND) or British Land (BLND), though this is a far less diverse way to invest as it’s just one company.
Exceptionally high net worth individuals can also buy a property outright and lease it to companies themselves; however this is without a doubt a risky way to gain access to the commercial property sector.
Within bricks and mortar funds, managers will usually invest in the whole range of commercial property: warehouses, offices, shopping centres and car parks. Furthermore, the property is divided by quality into prime, secondary or tertiary property.
Prime property is good quality property and is usually situated in big towns and cities with a string of high-quality tenants. Secondary and tertiary property falls into the near-prime category. It is not as good quality as prime property and good tenants are harder to find. As you would expect, there is a higher return to be made from these near-prime properties, as they are more uncertain.
Since the crisis of 2008, the commercial property sector has staged a slow but steady recovery. As stated by Money Observer data, the average property investment trust has gained 28 per cent over the past year to 1 September, whilst at the same time the average fund has returned 5 per cent. The commercial property sector has benefited from significant inflows once again: in July the Investment Management Association property sector attracted £57 million worth of investors’ money.
Nevertheless, there still remains some struggle in the market. Les Lang, partner at Infinity and head of the Infinity Real Estate Development Fund, points out, ‘A large risk in the commercial property sector is finding tenants for empty buildings’.
He further adds, “In addition, we have seen the market ‘split’ into two – property in good quality locations, which continues to be investable, and property in poorer, secondary locations that are often un-fundable and provide a poor return.”
What investors should be aware of
Investors should be wary of three key areas when investing in the commercial property sector: volatility, diversification and liquidity. On the positive aspect, property funds can be less volatile (excepting 2008’s crash), but are much less liquid. The staggering cascade of 2007 and 2008 are witness to the fact commercial property should be treated with caution. In addition, investors should observe a typical diversified approach.
Kearney says “Investors should be wary of funds that are too concentrated in one particular sector or region, a good spread of properties across retail, office and industrial should diversify sector specific risks.” He further adds, “In recent years, the office sector has performed best, but over ten years, returns in the retail sector were almost 30 per cent higher than offices. Investors should also heed caution with funds only holding a small number of properties, which increases tenant specific risks; ideally you are looking for a fund to hold at least 40 properties,” he says.
According to Lang, the main disadvantage of commercial property is that location and management of the property is ‘everything’. He adds: “Get this wrong and commercial property is a sector that can be unforgiving.”
Nevertheless, let’s not forget that commercial property funds can be slightly more expensive sector than traditional equity funds. As reported by the Morningstar data, the average initial charge is 4.66 per cent, while the average total expense ratio (TER) is 2.08 per cent.
However, property provides an ‘effective hedge’ against inflation and regular income. According to Lang, “Its illiquid nature also gives it a different cycle to bonds and equities – as such, it is an important element of any portfolio.”
According to F&C REIT’s Glover, the outlook for commercial property over the next years is ‘stable’. Glover predicts a total return of around 7-8 per cent from the sector over the next three years. He further adds: “We’ve had a house price correction, the downside risk has been reduced and there’s been a fall in capital values. There’s a good income return of 6 to 7 per cent to be made, which far outstrips gilt returns at around 2.5 per cent. It’s proved itself to be quite a defensive sector of late”, he says.
In conclusion, Glover states, “The sector isn’t very volatile and it has a low correlation to the stock market. In times when inflation is running at 5 per cent, it has some hedging characteristics, as well as obvious diversification benefits.”
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