Commercial property is anything that is not residential, so it covers a wide variety of buildings. As with build-to-rent, the most obvious entry point is to buy shares in a property company. But you need to do your homework first. All the usual tests need to be applied to gain some insight into a company’s true value, how it is run and where it specialises. It’s also important to establish a feel for which part of the cycle the property market is in at the time of investing. This can be harder than it appears at first because there are different types of commercial property and also areas where performance can vary significantly.
Office space in London, for example, could start to behave differently to the rest of the country because of its exposure to the financial sector and concerns about companies jumping ship when the UK leaves the EU. On the other hand, commercial property in the regions is currently a much more attractive investment. There are two reasons for that; the first is that regional centres are now attracting a lot of investment, notably from overseas. Secondly, in the years following the financial crash, new construction virtually disappeared there and has yet to catch up with growing demand.
Changes in consumer habits are helping to boost the big-box owner as major retailers look to develop their distribution centres to accommodate greater online buying, click-and-collect and home delivery. Finding sites close to major towns is difficult due to strong competition for land. So this is another sector where the companies involved are doing well. Retail is currently experiencing contrasting fortunes. Hypermarkets are less in favour following a move by shoppers to the convenience store market. Shopping malls are not all performing well, with much depending on how much the landlord adapts to making a mall more of a leisure experience, with the addition of features such as Wi-Fi.
What is a Reit and how do I invest?
A real estate investment trust (Reit) is pretty much like any other property company in that it owns and manages assets, buys and sells properties and collects rent. The difference is in the way that profits are taxed. Unlike non-Reits, where a company is subject to tax on profit and capital gains, after which shareholders pay tax on their dividends, Reits avoid paying any corporation tax on profit from their rental business, but have to comply with a number of conditions in order to achieve Reit status.
First and foremost, they must pay out 90 per cent of their net property income (excluding capital gains) to shareholders in the form of dividends. Reit shares can also be held in individual savings account (Isas) and child trust funds and, following a change in legislation in 2012, companies trading on the Alternative Investment Market (Aim) can qualify for Reit status. In addition, Reits must be involved primarily in property investment. As quoted companies there are generally no liquidity issues. There is currently some controversy over valuations, though.
Having traded at a premium to net asset value (NAV) for some time, shares in most Reits are now trading at a discount. Despite this, there has been no sign of Reits buying back their own shares, a sensible move if the shares were deemed to be undervalued. However, this is something that affects the property market as a whole, and the question remains how well the sector will perform in the wake of the EU referendum.
What’s the difference between developers and landlords?
The main difference is that developers are more often than not landlords as well, while landlords who are not developers will buy existing assets rather than building them. A property company acting as a developer has to make a fine judgement call based on the health of the economy and any indication of a change in trends. In the wake of the financial crash, many developers found themselves saddled with half-built properties, very high gearing, crashing property values and virtually no new tenant demand. Loan covenants came under pressure, and most property developers failed to avoid going cap in hand to shareholders for money.
Developers are that much healthier this time around. Gearing is significantly lower, so a drop in NAV will be a lot easier to bear. Secondly, there is a greater amount of development property already pre-let or pre-sold. Speculative building is not on the menu, not least because banks won’t lend on such ventures. Developers will sell assets when they have finished building them, but will also retain them in some cases, install a tenant and generate a rental stream. Signs of a healthy developer include a revenue stream that covers expenses and dividend payments. When there is plenty of uncertainty in the market, landlords will try to secure longer leases with tenants in order to provide greater earnings visibility, ideally including annual upward-only rent reviews.
Should you make direct investments in commercial property?
This can be achieved by purchasing your very own shop or restaurant or any other asset that generates revenue. However, it would be very unwise to do this unless you set up a limited liability company. By doing this you avoid any of your personal assets being sucked into the venture if it all goes wrong. This is a line that not many potential investors will want to take because it will involve a significant capital outlay. And borrowing money is a non-starter unless you have a business plan that your bank likes.
You also have to consider what you will do with a property. Do you start your own restaurant or specialist shop? In which case you are starting a business for which acquiring ownership of a property is not an essential prerequisite. Unless you have the commitment to engage in running a business, it’s far more sensible and less stressful investing your money in someone else with the financial backing, experience and knowledge. Identifying such an investment opportunity will be taxing enough.
Taking advantage of change of use rules
In 2013, the government introduced measures to help address the shortage of housing by permitting a change of use from offices to apartments without the need to secure planning permission. As it turns out, it wasn’t that simple because many local authorities sought exemption on the grounds that office space was more important than residential space, notably in inner cities. And while there was no need for planning consent, you still needed consent to make any external changes.
Local authorities also retained the right to intervene on highway safety grounds, contamination concerns or because of flood zones. Perhaps the most noticeable change has been in the number of abandoned public houses that have now been converted into apartments. For local authorities, the changes are broadly bad news because no longer will they be able to gather in Section 106 funding that could be used to improve the infrastructure deemed necessary with any new development, such as pavements and lighting.
Alternative routes into property
Student accommodation
Student accommodation is changing. Renting a house with three other people is still an option, but for overseas students that has less appeal. Parents sending their children to a different country are attracted by the idea of purpose-built accommodation within a building that offers a variety of other facilities.
As a business investment, building student accommodation really started to take off after the government lifted the cap on overseas student numbers. UK universities were already increasing the number of student places, but demand continues to outstrip supply by a considerable margin. In the 2015-16 academic year, for example, 532,000 applicants were awarded places at UK universities. That’s up 92,000 from the previous year, but still way short of the total number of applicants at 718,000. Apart from the high-quality education on offer, rich parents will also be attracted by the increase in spending power as a result of sterling’s depreciation.
Companies involved in providing new digs usually work in conjunction with universities in an attempt to assess demand and ensure that new students are made aware of the facilities on offer. However, higher rents can be charged to students who book directly, and while new accommodation is being built all the time, it will be some time before the supply/demand imbalances starts to narrow to any extent.
Ground rents
In practical terms, the only way to invest in ground rental income is to buy shares in a company that holds a portfolio of freeholds on properties leased out. The business model is simple enough. Having bought the freehold, the company collects the ground rent. It sounds boring, but it is safe. Anyone buying a property on a leasehold basis will do everything to ensure that the ground rent is paid. The alternative is simple; the freeholder gains possession of the property. Bad debt exposure is therefore almost non-existent.
In addition, the revenue stream is almost completely divorced from the uncertainties generated by the UK’s exit from the EU. One of the main operators is a real estate investment trust called Ground Rents Income Fund (GRIO). It has virtually no gearing, and the forecast dividend yield is over 3 per cent; not the highest in the world, but probably one of the safest. The portfolio is spread over residential, retail and commercial properties, with leases running from 99 years to 999 years. The only downside is that it is becoming more expensive to acquire freeholds as more players enter the market. The upside from this is that Ground Rents’ portfolio increases in value.
Healthcare centres
Financial constraints and a lengthy restructuring of the National Health Service (NHS) have left primary healthcare services – that’s doctors at the coal face – badly in need of fresh funding. Some resources have been made available, and it’s frustrating that more funds are not put forward because for every £1 spent on primary care, the NHS saves £5. This is because it costs much less to visit a doctor than it does to clog up A&E departments with relatively trivial and non-emergency ailments that could have been treated in a doctor’s surgery, if they were open, which at weekends they’re not.
Providing a modern healthcare centre means that other facilities can be made available, such as X-rays, a pharmacy and physiotherapy. However, most surgeries are not suitable for upgrading, and the way forward is to build modern health centres. Three quoted companies specialise in making these happen: Primary Health Properties (PHP), MedicX Fund (MXF) and Assura (AGR), all of which offer an attractive dividend payout. Tackling the 10,000 surgeries, most of which are unfit for modernising, is something of a slow burner, especially as there is also a shortage of GPs. However, the prevailing pillar of support for all three companies is that the tenant who pays the rent is the UK Treasury. And while progress has been painfully slow, it is hard to disguise the social and economic sense of having more modern healthcare centres.
Investing in care home operators requires a lot more thought because it takes a good deal of effort to fight against the cuts in funding that put pressure on rents. This is manageable, but in the past some operators have borrowed heavily to expand the bed network only to struggle later when local authorities cut back on social care spending.
Non-traditional investment vehicles
These are popping up almost daily, and have been spawned largely out of the reluctance of major lenders to actually lend money to small enterprises. All manner of schemes are on offer to help small- and medium-sized companies to raise relatively small amounts of capital that the so-called small businessman’s friend chooses to ignore. Looking exclusively at property, the continued rise in property values has helped to create a number of investment opportunities whereby an investor can put relatively small amounts into the rental sector without all the hurdles associated with conventional buy-to-let.
There is a worry that the business model has not stood the test of a downturn, and the key here is that it must be sufficiently resilient to survive market weakness. If it can, then property has shown that over a longer period it is a solid investment, beating cash, fixed interest and equities. Here’s how it works. The property company buys a property and raises a mortgage. The difference between the mortgage and the purchase price is funded by private investors who, through the company’s trading platform, indicate how much they are willing to invest. That investment will receive in return a share of the rental income, and the relevant gain from any capital appreciation.
Management fees, legal fees, broker fees and letting agent fees all eat into the return, but there is still scope for an attractive return. In some but not all cases, investors can sell their stake through a secondary market set up on a trading platform, although how much you get back depends largely on whether there is anyone looking to buy your stake. This is a tough one. If you sold in a declining market, you might lose money. On the other hand, there may be someone who views the market as an ideal time to invest to take advantage of an upturn when it comes. A long-term investment property is much more likely to earn you a decent return.
Summary
Every investment vehicle has its detractors, and real estate in its many forms is no exception. And it’s perfectly easy to lose money investing in property, but over time those losses can be recouped because land is a finite commodity. Where some people come unstuck is through buying at the wrong time and borrowing too much money. This toxic combination does its deadly work when as a property owner you are faced with falling values and a tenant that has gone bust or simply run away. But if you get the timing right, then increased gearing will generate significantly more income. Ultimately, you have to decide how much risk you want to build into your portfolio.
When times are tough, a property company with low debt, a fully reined in development arm and a solid and diverse rental income stream is the ideal choice. If you want to increase the risk/reward ratio, then timing is everything.
