Britain is a nation of property lovers. But rather than buying a residential property, how about buying a part of the local high street by 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. While the market has since mostly recovered, property prices are still around 30 per cent lower than their 2007 peak. More recently, ongoing market volatility and uncertainty about the global economy has raised interest in the commercial property sector, as investors look for safe haven investments.

The basics

The commercial property market is made up of shops, industrial buildings like warehouses, and offices. Investment funds then buy these units and rent them out to other companies on long leases, making a profit from the rental income as well as the capital growth in the price of the property.

The sector traditionally has little correlation with equities and bonds, meaning in times of volatility, commercial property can help to preserve wealth. It is popular with income seekers, as it pays a regular yield in line with rental payments.

The sector has garnered interest among investors as it’s tangible, according to Guy Glover, fund manager at F&C Reit Asset Management. ‘It’s a real asset, something investors can touch and feel,’ he says.

Since 2007, the market has gradually got itself back on its feet, and is fast becoming an attractive investment again. David Paine, head of real estate at Standard Life Investments, continues to regard global commercial property as an ‘attractive component’ of a ‘diversified, multi-asset portfolio’. ‘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,’ he says.

Investing

There are several ways to invest in commercial property, either directly or indirectly. Investing indirectly through a fund or trust, which will invest in a variety of different properties, is an easy and less risky way to access the sector.

‘For most investors, the most appropriate way to invest in commercial property is via a collective investment scheme like a fund or a trust,’ 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.’

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, while a property securities fund will invest in the shares of property companies. The former 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, the funds can be very illiquid. Conversely, a property securities fund invests in listed property companies and so is far more liquid, but subject 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, although this is a far less diverse way to invest as it’s just one company. Ultra-high-net worth individuals can also buy a property outright and lease it to companies themselves, although this is without question a 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 with a string of good quality tenants. Secondary and tertiary property falls into the sub-prime category, and is not as good quality, with good tenants harder to find. Naturally, there’s a higher return to be made from these sub-prime properties, as they are more risky.

Since the crash of 2008, the commercial property sector has staged a gradual but stable recovery. According to Money Observer data, the average property investment trust has gained 28 per cent over the past year to 1 September, while over the same time period the average fund has returned 5 per cent. The sector has benefited from considerable inflows of late: in July the Investment Management Association property sector attracted £57 million worth of investors' money.

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, partner at Infinity and 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.

What investors should be aware of

When investing in the commercial property sector, investors should be wary of three key areas: volatility, diversification and liquidity. On the upside, property funds can be less volatile (excepting 2008’s crash), but are much less liquid. The staggering falls of 2007 and 2008 are testament to the fact commercial property should be treated with caution.

In addition, investors should heed a typical 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. ‘In recent years the office sector has performed best, but over 10 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.’

Meanwhile, the main disadvantage of commercial property is that location and management of the property is ‘everything’, according to Lang. ‘Get these wrong and commercial property is a sector that can be unforgiving.’ It’s also worth remembering that commercial property funds can be slightly more expensive sector than traditional equity funds. According to 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 a regular income. Lang adds: ‘Its illiquid nature also gives it a different cycle to bonds and equities – as such, it is an important element of any portfolio.’

The outlook for commercial property over the next few years is ‘stable’, according to F&C Reit’s Glover. He predicts a total return from the sector of around 7-8 per cent over the next three years. ‘We’ve had a house price correction, the downside risk has been reduced and there’s been a fall in capital values,’ he says. ‘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.’

Glover concludes: ‘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.’