Time to add commercial property to your portfolio?

The below article has been paraphrased from the coverage on commercial property in The Financial Times' Money magazine on 9th August 2013. Subscribers can view the full article here as well as the supporting links embedded below.

It may have been one of the hottest days of the year but that did little to stop the crowds gathering inside a high-end hotel on London’s Park Lane last month. The hotel was hosting an event where ordinary individuals could spend hundreds of thousands, or even millions of pounds, with just the briefest nod of a head.

But this wasn’t an auction of fine art, antiques or jewellery. It was a commercial property auction run by Allsop, the UK’s biggest property auction house, selling corner shops and scruffy offices. At times the bidding was fierce; at others fairly lacklustre.

That’s a fair reflection of the wider market. Five years on from the start of the downturn, the fortunes of the UK’s commercial property market remain extremely varied. Property in London is doing well, particularly the central London office sector, which is seeing strong demand from overseas investors. In comparison, property outside London continues to struggle despite prices being as much as 40 per cent below their pre-crisis peaks.

Figures from IPD, the property value benchmarking group, collated for FT Money, show the extent of the price falls since the market peak in 2007. The biggest decline has been in cities including Derby, Swansea and Plymouth, with property values still down 46.1 per cent, 45 per cent and 44.4 per cent respectively. Even in central London, where a recovery has been taking place, values are still down 13 per cent. By contrast, the FTSE All-Share index has retaken its 2007 highs – and has doubled since its low point.

But there are signs that the real estate market is finally turning a corner. Capital values rose 0.4 per cent in the second quarter of the year, halting an 18-month decline in which average values have fallen 3.5 per cent since September 2011.

Experts say recent positive economic indicators are helping the asset class. Provisional figures from the Office for National Statistics indicated that the UK’s GDP grew 0.6 per cent in the second quarter, while the services sector expanded at the fastest rate in more than six years in July, survey data released on Monday suggested.

“The UK’s recent economic improvement has begun to filter through into property returns, and the wait for rental growth outside of London is over – an important signal for improved tenant demand,” says Greg Mansell, head of applied research at IPD.

The improved outlook and the attractive income returns on offer have encouraged private investors to take more interest in commercial, as opposed to residential property. Auction houses say they have seen an increase in the number of first-time commercial property investors in recent months.

Duncan Moir, partner and auctioneer at Allsop, says: “The pressure on investors from the continuing low interest rates is forcing many to look at other ways of securing a return on cash. Property fits this requirement. It is also ‘kickable’ and gives the investor a higher degree of control.”

Across the sale rooms, retail remains particularly popular. Out of the 134 lots offered at Allsop’s July auction, more than 90 were classed as retail.

“Typically, private investors’ favourite commercial property investment is a shop with a flat or flats above it,” says Graham Gould of the property-focused Coba Asset Management. “Offices and industrial property tend to require more specialist knowledge and asset management capabilities.”

One of the most successful sales at the Allsop auction was that of a parade of shops on North Pole Road in north Kensington, west London, which also had development potential. The lot of four shops sold for £870,000, nearly twice the pre-sale guide price, providing the buyer with a 4.66 per cent net yield.

In response to the demand for property from wealthy private investors, Coutts, the private bank, launched a real estate investment service in May this year. Stephen Rees, who heads up the advisory arm, says 80 per cent of the interest is for central London buildings.

“There is a general belief that if I own a very good building in a very good part of W1, I will always be able to sell it,” says Mr Rees. In the past month, Coutts has bid on six buildings in central London on behalf of clients, with a combined value of £350m.

It is this part of the commercial property market that has seen the biggest turnround over the past two years. As with residential property, the central London commercial market has seen strong demand from overseas institutional investors, such as sovereign wealth funds, looking for a safe haven for their money. The effect is that yields – the rent take as a percentage of the capital value – have been compressed to about 4 per cent.

Hans Vrensen, global head of research at DTZ, a property consultancy, says some parts of the prime central London market have become overpriced.

“Right now, we think West End retail is already there, but there is a danger that other sectors of the prime central London market could become overpriced too,” he says.

Many property experts says the biggest opportunities for investment lie in the regions, not the capital. In June, Investec Wealth, the wealth manager, announced it was moving its discretionary clients to an overweight holding in UK commercial property over the next 12 months, with the best opportunities outside London.

Andrew Jackson, head of wholesale and listed real estate at Standard Life Investments, says it is starting to buy outside London and the South East in certain markets.

“It’s very much a barbell approach. Where we were focusing more on London, we’re now spreading that out to some of the other cities that haven’t been experiencing growth,” says Mr Jackson.

Mr Vrensen also thinks the regions will pick up: “We’ve been saying that for a little while now. It’s been a bit slow to come around because of the lingering risk aversion from investors.”

One reason why investors have been slow to look outside of London is that concerns remain about the amount of distressed property assets held by banks. While banks have been slower than in previous downturns to shift these assets, experts say there are signs they are starting to offload their loan portfolios to take advantage of the improved economic conditions. This could result in further price falls.

But the higher yields on offer from regional property – typically about 8 to 9 per cent – are starting to attract private investors. Some parts of the secondary market can provide double-digit yields.

“If you can stomach the risk, then the excess return you get on secondary UK property at the moment is certainly very attractive,” says Mr Vrensen. “Yields are almost double that of prime central London, but we do not expect to see double the risks.”


Comment: Attractive prospects lie beyond London

Sentiment towards UK commercial property is improving, after a very tough period for the market since the credit crisis of 2008. In fact, 2013 is proving to be a positive turning point, as there are more signs of UK economic growth and an emerging revival of the sector, writes Philip Nell.

There are several reasons for this. Property values are increasing again and we believe that this, coupled with attractive income prospects, could deliver total returns for the commercial property market of more than 7 per cent in 2013. We expect strong returns to continue into 2014 with the best investment opportunities likely to be found outside of London.

In the secondary market, where tenant quality tends to be lower and income flows shorter-dated than for prime assets, yields are particularly attractive. This has raised demand for properties with potential to add value through regearing leases or upgrading tenants, and marks a significant shift from 2012, when few investors were willing to take on such risk. With investor interest moving to higher-yielding areas of the market, sectors such as industrials and offices outside central London could outperform over the medium to long term.

Although occupier markets remain weak, the supply of new buildings is severely constricted. Construction output levels remain depressed and the value of new construction orders is close to a historic low. Excluding central London offices, new supply is likely to be extremely limited over the next few years, and selective strategies targeting better-quality secondary assets should outperform. In retail, this means big shopping centres in major urban centres, with quality tenants. Smaller shopping centres have suffered more from the impact of retailer administrations and online retailing.

Philip Nell is manager of the Aviva Investors Property Trust


Case study: More yield, fewer headaches

Gary Hyams decided to take the plunge into the commercial property market for the first time this year, buying a shop in a town in North Lanarkshire, Scotland, writes Tanya Powley .

The 57-year-old business development manager already owns a number of buy-to-let properties in Essex but was attracted by the yields on offer in commercial.

“If you pick the right commercial property, I think you can do a lot better than buy-to-let,” says Mr Hyams. “You can get a much higher yield for a similar sort of cost.”

His decision to buy a retail property in Airdrie – between Glasgow and Edinburgh – was down to the quality of the tenant and the location. The shop is let to opticians chain Specsavers on a lease till 2018, and has Boots and O2 next door. Mr Hyams’ purchase will provide him with a net yield of 12.6 per cent.

“I didn’t want something that was just a one- or two-man-band shop because of security of tenancy,” he explains.

One of his main considerations when deciding whether to invest in a commercial property was that it typically comes with a full repair and insuring lease, meaning that the tenant is picking up all these costs.

“As a landlord of a buy-to-let property, you are picking up the costs and yet you don’t have a continuous tenancy,” says Mr Hyams.

While he knows there are risks in the retail market, especially with shops closing, he believes confidence is coming back. “Over the past two or three years the tree has shaken and a lot of fruit has fallen out, and what is left now is actually quite good fruit,” he says.

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