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You are here: Commercial Property
 
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Education

Commercial Property

 

Why invest?

Why invest in commercial property?
One of the most widely accepted principles of investment is that diversification reduces your risk. There are a variety of reasons why private investors should consider commercial property as part of their overall investment portfolio. These include:
Income yield
While the yield generated by government bonds – gilts – has fallen markedly over the last 15 years, the yield from property has remained surprisingly stable [f]. In fact, property yields have been locked in a 5%-8% range for the last 10 years [f].

The average income yield from commercial property of about 5.78%[f] at 31-Jan-2005 is especially attractive in today's low inflation environment. The income return on property equates to a real (i.e. post-inflation) return of 3.78% if inflation meets the government target of 2% (as measured by the Consumer Prices Index). In comparison, before any inflation adjustment UK shares yield a little more than 3% [g] and gilts offer about 4.7% [g]. While dividends from shares may increase over time, the income from gilts is fixed.

The system of regular reviews means that property rents can keep pace with inflation. The rent review process takes account of rents on similar properties. In addition where existing leases are being extended, upward only rent review provisions stop rents falling to market levels on the extended lease. General market conditions will also have an impact, for example in the early 1990s, when rents for new tenants fell significantly below those paid by existing tenants.

Please note that the value of commercial property and the associated rental income can fall as well as rise.

Sources: [f] Investment Property Databank 01-Feb-1989 to 31-Jan-2005, [g] Financial Times 25-Feb-2005.
 
Diversification
One of the most widely accepted principles of investment is that diversification reduces your risk. In the context of shares, this means that you should hold a broad spread of shares across the main market sectors rather than just a handful of shares. A range of holdings – as provided by a unit trust or OEIC – will mean that if one company fails, you do not lose all your money.

You will still not however, be immune from a general decline in stockmarket values, as happened between the start of the new millennium and early 2003.

This is where diversification across investment classes plays an important role. While UK shares (FTSE All Share Index Total Return) grew strongly in the latter part of 2004, they were falling for two and a half years from Autumn 2000. During this period of volatility, commercial property was averaging a 12.9% a year return (to end 2004) [h]. If you had a portfolio that included shares and commercial property, it is likely that you would have fared better than the investor who held only shares. Please bear in mind that past performance is not necessarily a guide to the future.

The diversification argument applies if you invest in government bonds and other fixed interest securities.

The market cycle for commercial property is not closely linked with that of bonds or shares. According to research by some of the leading investment banks, over the period 1970-2002 there was only a limited correlation between the performance of commercial property and that of UK shares and gilts [i]. Gilts were much more closely correlated with UK shares than property to shares or property to gilts.

The point has not been lost on institutional investors, who have increased their exposure to commercial property in the past few years.

Sources: [h] Investment Property Databank, [i] Investment Property Forum.
 
Volatility
As we show in the following section on performance, returns from commercial property investment have been much less volatile than those from investment in shares. Part of the reason for this is the high level of income, which makes property investment similar in some respects to investment in fixed interest securities.

Commercial property has only produced negative returns in three of the last 20 years, with a maximum loss of 8.4% in 1990 [h], during which year bank base rates were at 15% [j]. Across the same time-frame, UK shares have posted five losing years, with the biggest overall loss of 22.7% in 2002 [h].

Sources: [h] Investment Property Databank, [j] 2003 Taxbriefs.
 
Tax
The UK tax regime has two important features that can make property an attractive investment for certain investors:

For tax purposes, interest on loans to finance the purchase of property can be offset against rental income. As a consequence, certain investors who are prepared to borrow heavily can minimise the tax they pay on rental income. Borrowings for other types of investment do not generally attract such favourable tax treatment.

Rental income is normally received by investors without deduction of tax. This is particularly important for tax-exempt bodies such as pension schemes, which have been unable to reclaim the tax credit on UK dividends since July 1997.
 
Yield calculations
Rental yield is one of the most commonly quoted yardsticks for comparing property investments. At its simplest, yield is calculated as Rental income/Property value x 100%

So, for example, if an office property is worth £15,000,000 and has rental income of £900,000, its yield is calculated as: £900,000/£15,000,000 x 100% = 6%

A property's yield can vary as a result of a change in the rental income and/or the property value. For example, if the rent on the office property increased to £1,200,000, the yield would rise to 8%. For its yield to stay at 6% with the higher rent, the property's value would have to rise to £20,000,000.
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