BALANCING THE WEALTH MANAGEMENT PORTFOLIO: THE BENEFITS OF INVESTING IN COMMERCIAL PROPERTY
Land and property has a place in many balanced investment portfolios. However many people’s knowledge of property is limited to the residential sector and their own housing – meaning that some investors will not consider commercial property as an option.
In this article, Ian Froome, partner at property consultancy Vail Williams, outlines some of the key characteristics of land and property as an investment vehicle, focusing principally on the commercial aspects.
As with any investment, there are positives and potential negatives when it comes to considering property.
- Property is a tangible and finite asset. All investments carry an element of risk, but with property – no matter what happens – the owner will always have the land, and with that comes an opportunity to rebuild the investment value
- Land and property is an easily understood asset class, at least at a superficial level. It is the nuances of tenure, leases and covenants that need expert care
- Property is an investment with a very long shelf life. Some buildings suffer obsolescence, but that is usually also an opportunity to redevelop and create additional value. The underlying land does not ‘mature’ or terminate as with some other investments
- Most commercial property investments are leased on a ‘full repairing and insuring’ basis, meaning the tenant is responsible for all costs relating to that property. This is a key difference from residential property, where the landlord remains responsible for buildings insurance and external repairs. Multi-let commercial properties (such as an office building with a different tenant on each floor) allow the landlord to recover shared building costs through a service charge. In most cases, the landlords can even include management costs within this service charge, meaning the rental income is generally a clear net income.
There are also potential pitfalls to property investment that need to be considered alongside the benefits. In most cases these pitfalls can be avoided or even made into a virtue or opportunity.
- Some classes of property investment are prone to ‘bubbles’ but this is true of most asset classes and the resultant crashes do have limits
- The often-quoted example is residential; we are all waiting for the next house price crash. If the underlying characteristics of the investment are right, however, this risk can be mitigated, even if Woolworths were your tenant
- If the unlucky property investor sees values falling, that fall is limited to the underlying value of the land – it won’t disappear into nothing like a 1990s dot.com share investment
- Property can suffer a lack of liquidity, especially when funding sources are limited
- For example the recent recession and credit squeeze reduced the number of buyers, so sale periods were longer than average
- There can be significant holding costs for vacant commercial buildings. These include insurance and empty property rates which can be substantial. This means that the long-term security of the lease is a key factor when pricing a commercial property investment
- Quality property investments can be hard to find. This can of course be a virtue for those lucky enough to hold good quality stock since the excess of demand over supply can help capital growth.
The nature of supply and demand
One of the key challenges for property investors is finding good quality stock. This has been exacerbated in recent years by the dearth of new development. As the economy improves there will be more money seeking an investment home, boosted by initiatives such as the Bank of England and HM Treasury’s Funding for Lending scheme.
This potential growth in demand linked to static supply might well lead to a bubble where people pay over the odds for average investments just to secure something. Investors need to make sure that they don’t lose sight of the fundamental characteristics of any investment when buying property – don’t just follow the herd.
Pricing property investments
Any investment should be priced on two fundamentals: firstly the security of the income, and secondly the potential for income or capital growth.
One of the main differences between residential and commercial investments is that most buy-to-let investors seek growth mainly through capital value appreciation. A commercial property investment should rely much more on the income growth potential.
Some sectors provide a good secure income but limited growth, for example offices let to strong covenants on long leases. Others offer less security but better income growth prospects – an example would be an industrial unit on a sought-after estate but let on a short lease. A precious few offer both strong income growth potential and good security, an example being a modern and well located convenience store let on a long lease to one of the major supermarket chains.
There are many specialist ways to hold property, but popular niche opportunities include:
- Hold in a SIPP (Self-Invested Personal Pension)
- Particularly tax efficient for business owners with freehold property
- Does not apply to residential property
- Hold in an associated company
- Impact on the balance sheet, may be positive on net asset value
- May have tax implications if the value of the company increases
- Note that a leasehold property where a ground rent is payable may be a liability on a balance sheet
Permitted development – from office use to residential
A major change to planning legislation this year is the introduction of permitted development rights allowing, in certain cases, a change of use from office to residential.
The potential to convert to residential use may provide a lifeline to the owners of older office buildings, or ones that are no longer in suitable commercial locations. However the rights are not unfettered and some planning controls still need to be faced, for example on the traffic impact, flood risk or any major changes to the structure of the building. If these are an issue then a planning application would still be needed. Nevertheless the legislation signals a clear intent to the principle of the use change which could help to de-risk some office investments.
Looking at the investment market from an international perspective, the UK is seen as a safe haven for investors. We have a stable political and legislative framework that encourages long-term investment options – attractive to investors from less secure environments.
Like all investments, the property market experiences peaks and troughs. It is vital therefore to take a long-term view and also to spread risk in a balanced portfolio – investing across different property types and / or locations. Such a healthy approach should ensure healthy returns.
For more information about Vail Williams LLP, please visit www.vailwilliams.com