Investing in commercial property can be a smart way of spreading or diversifying risk in a property portfolio.
This is because property isn't generally highly correlated to other assets classes such as fixed income (bonds and gilts), cash and equities. This allows commercial property values to move independently of other assets and not be typically affected by what's going on in the stock markets.
There are two principal ways for you to earn money from a commercial property investment: income from renting to a tenant and capital growth from an increase in the value of the property.
However, there are benefits and pitfalls of investing in commercial property. Here we evaluate the advantages and disadvantages to help you make the right decision.
Key Considerations Of Buy To Let Property
Investors in buy-to-let residential property may need to borrow in order to get their foot on the ladder. To get a mortgage, you'll need a much higher deposit – generally between 20% and 40% of the value of the property.
You should expect to pay higher interest too. This is because there's more risk for the lender, because if you may have periods of no rental income if your tenants don’t pay their rent or the property sits empty for a time. Your mortgage charges will be higher too, as you may have to pay set-up fees.
Lenders take not only take the size of the deposit you have into consideration but also how much rental income the property will generate. Typically, lenders accept rental income of 125% – that’s 25% over your monthly mortgage repayments.
Calculating The Return You’ll Get From The Property
Rental yield gives you an indication of what kind of return you'll be getting from the property and is an important figure to have in your mind if you're thinking of investing.
It’s based on the costs you may be faced with when you become a landlord, of which the biggest will be your mortgage, but there are others fees to consider, such as buildings insurance, ground rent, maintenance costs, charges and letting agency fees.
Once you have deducted all the costs from the amount of rent you receive, the figure you end up with is known as the 'net rental income'. The rental yield is calculated by dividing the net rental income by the value of your property.
What You Need To Know About Commercial Property Funds
There are three categories of commercial property: retail, office and industrial. These types of property can command huge rental incomes but can be impossible for smaller investors to buy outright, as they may cost millions of pounds to purchase or build.
Most investors therefore consider direct commercial property funds as the most common way to invest in commercial property. This is done via a collective investment scheme, such as a unit trust, Oeic or investment trust.
These trusts either directly own properties and pay you returns based on their growth in value and rental income, or buy shares in property-related companies, paying you returns based on the growth in the value of the shares and the payment of dividends.
The typical lease length in a London office is generally between 10 and 15 years, while the average lease length across all of the UK is approximately eight years. In comparison a residential property generally has leases of six months to a year.
As income is guaranteed at a set level for an extended period of time with this type of investment, it potentially offers more security relative to the returns offered by shares.
Understanding Direct Commercial Property Funds
This type of fund refers to the actual physical properties are bought by the fund and are often referred to as ‘bricks and mortar. Risk is distributed across several different properties meaning that if one property is not occupied and bringing in no rent then others within the fund can generate income.
Your returns come from a combination of increased value of the properties in the fund and, more importantly, the rental income.
With direct property funds, rental income can be relatively secure in comparison with other asset classes because of factors like long lease lengths (typically five years or more), less risk of default than residential properties, and upward-only rent reviews, meaning that rental income increases by at least inflation each year.
You also don't have the hassle of property management, which falls to the manager of your fund. It's the manager's responsibility to source tenants, invest in property in prime locations and negotiate lease lengths.
A major downside of direct investment, however, is that property markets are highly illiquid compared with most other financial markets, meaning that buying or selling property can take months, and can make it difficult to sell your holding in the fund quickly.
When the financial crisis hit and property values plummeted, many direct property fund investors found they could not take their money out. This is because property funds have a clause that allows fund managers to shut off payments to investors wanting to exit the funds if there are "exceptional circumstances."
The clause denotes that property funds can suspend trading for a recurring 28 day period while they try to raise enough cash by selling properties to meet redemptions. During the financial crisis of 2007-08, some of the freeze on people leaving funds lasted as long as 12 months.
An Evaluation of Indirect Commercial Property Funds
Indirect Commercial Property Funds buy shares in companies that invest in property and are usually in the form of unit trusts and Oeics. They are listed on the stock exchange and don't have the liquidity problems of direct commercial property funds, meaning you can move in and out of the fund freely.
However, while these funds give you the benefit of the liquidity of an equity-like product, you also get the volatility of investing on the stock market. Returns are gained through share-price appreciation and dividend income, rather than directly through property price increases and rental income.
Real estate investment trusts
The vast majority of these property companies are known as Real Estate Investment Trusts (REITs). They generally have greater tax benefits than other listed property companies as they don't pay corporation tax on their assets.
This is on the condition that 90% of profits are paid to shareholders as dividends, which, in turn, could mean higher payouts. REIT investors also pay either 20% or 40% tax, because they're classed as property-letting income.
Property Investment Trusts
Property investment trusts pool your money to buy property and property company shares and are considered to be like any other company. Tax on dividends for the 2019-20 tax year is 7.5% for basic-rate taxpayers on any dividends over £5,000. This increases to 32.5% and 38.1% for higher and additional-rate taxpayers.
Investment trusts can do things that unit trusts and OEICs can’t, such as gearing – a process whereby the companies borrow money – to boost the amount they can put into property beyond what you have invested. However, while this can improve gains in an expanding market, it can increase losses if returns drop.