How to invest in commercial property: a beginner's guide

A beginner's guide to commercial property

Britain is a nation of property lovers. But rather than buying a residential property, how about investing in commercial property?

The asset class hasn't always had an easy ride. In 2008, commercial property prices fell by an unprecedented 44 per cent almost overnight as the US sub-prime mortgage crisis resonated around the globe and prices outside of London are only now starting to regain their lost ground.

Since 2007, the market has gradually got itself back on its feet, and is becoming an increasingly attractive investment again.

Mat Oakley, head of commercial property research for Savills, points out that while the price of property in premium areas such as London has largely recovered, there could still be value in the other areas, not to mention potential rental income.

'The attraction of UK commercial real estate is that you get capital growth and income return,' says Oakley. 'Certainly if you were looking to capture the capital yield bounce from 2007/08 in the premium markets you might have missed it.

'But when you get outside London rental growth is only just going positive. The prospects for rental growth are starting to accelerate.'

The basics

The commercial property market is made up of shops, industrial buildings such as warehouses, and offices. You can typically invest directly by investing in a fund which holds actual physical property in its portfolio or by buying a property yourself, or indirectly by investing in funds exposed to property companies, developers and housebuilders, for example a real estate investment trust (Reit).

'Direct' property investment funds or trusts buy these units and rent them out to other businesses on long leases, making a profit from the rental income as well as (hopefully) capital growth in the price of the property. This makes them popular with income seekers, as rental income typically rises in line with inflation.

For ideas on which funds and trusts you can invest in, view Money Observer's Rated Funds in the property category.

Bricks and mortar traditionally has little correlation with equities and bonds, so in times of volatility commercial property can help to preserve wealth. 'The only time there is a correlation is when property rents are falling,' says Oakley.

'For many investors, the most appropriate way to invest in commercial property is via a collective investment scheme,' says Gordon Kearney, investment director of Colchester-based Fiducia Wealth. 'Property funds on the whole are a cheap and easy way to gain exposure to commercial property as an asset class.'

As mentioned above, investment funds and trusts providing exposure to the sector are divided into two types. A traditional bricks and mortar fund will invest in the property directly, and be structured as either an open-ended fund or a closed-end investment trust.

It will physically buy the property and be responsible for its maintenance and rent collection, and have the added benefit of a regular rental income. However, as offices and warehouses are not easily bought or sold, such funds can be very illiquid.

Conversely, a property securities fund invests in the shares of listed property companies and so is far more liquid, but exposed to the ups and downs of the stock market.

Investors can also buy shares directly in a Reit (real estate investment trust) such as Land Securities or British Land, which runs a portfolio of properties, although this is a far less diverse way to invest as it's just one company.

Those who can afford it can also buy a property outright and lease it to companies themselves, although this is without question a labour and capital-intensive - not to mention risky - way to gain access to the sector.

Within bricks and mortar funds, managers will typically invest in the whole spectrum of commercial property: offices, warehouses, shopping centres and car parks. In addition, the property is divided by quality into prime, secondary or tertiary property.

Prime property, much as the name suggests, is good-quality property, usually situated in big towns and cities and attracting a string of top-drawer tenants.

Secondary and tertiary property is situated in less prime locations, with high-quality tenants harder to find. There's a higher yield available from these sub-prime properties, as the risk of void (empty) periods and defaults is higher.

What to be aware of

Since the crash of 2008, the UK's commercial property sector has staged a recovery. However, there remain some struggles in the market. A large risk in the commercial property sector is finding tenants for empty buildings as Les Lang, head of the Infinity Real Estate Development fund, points out.

'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,' he says.

Property investors should be wary of three key areas: volatility, diversification and liquidity. On the upside, property funds can be less volatile than those focused on other assets, but direct property funds in particular are much less liquid because you are selling an actual property.

It can be especially hard to sell in a market crash. Note that open-ended funds are particularly sticky because the fund manager has to cash in units - meaning selling property.

Closed-ended funds like investment trusts are more liquid because you just need to sell the shares in the trust, not the underlying assets.

In addition, investors should ensure they take a well-diversified approach. '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,' says Kearney.

'They should also be cautious 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.'

The main disadvantage of commercial property is that the location and management of the property is 'everything', according to Lang. 'Get these wrong and commercial property can be unforgiving.' It's also worth remembering that commercial property funds can be slightly more expensive than funds invested in other assets.

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.

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When we write about

When we write about commercial property, we’re talking about office space, retail stores, industrial units and warehousing; basically any building or structure suitable for operating a business. This of course means that commercial investment opportunities vary greatly in size, location, and cost; but importantly, also in risk and return.

Another point in addition

The property is rarely a representation of the owner. Office space, retail stores, and industrial units are almost always rented out without reservation. If the company can pay rent, they almost always get the space. And as one of the biggest commercial property owners told me recently, the major difference between commercial and private is that private renters will destroy an apartment, while commercial will try to improve the property.

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