Although the media headlines often concentrate on the purchase of residential property for investment purposes, many canny investors are moving toward commercial properties to help diversify their portfolios. This makes a lot of sense, as having all of one’s eggs in one basket can lead to trouble.
Property values often move independently of other asset classes and are typically not associated with fluctuations in the stock market. This gives the investor a good opportunity to spread their risk and even out their investment strategy.
What does commercial property mean?
Commercial property generally covers all types of property that are purpose built with the intention of making an ongoing profit. Just some of these are:
- Industrial units
- Retail developments
- Eateries, such as restaurants and cafes
As you can see, the term covers a broad spectrum and it is this diversity that gives commercial property investment its appeal.
Why should I invest in commercial property?
Commercial property is attractive for a number of reasons, but it is the lease structure in the UK that often tips the balance for investors. Here we have a far longer length of lease for commercial properties than in either the US or Europe, and this can work in the investor’s favour.
London leases can be between 10 and 15 years while the rest of the UK still averages out at around 8 years. Compare this with a residential property lease of 6 months and it is easy to see why investors like the idea of putting their money into commercial property.
Diversification is obviously another reason why so many investors choose to enter into the property market. Dealing in physical assets can bring about a relatively stable income return when compared to other investments such as the stock market.
Property is currently performing well and it has recovered fantastically after the dark days of 2008. When looked at alongside the current rates of interest available from savings accounts, commercial property becomes all the more attractive for those with a long-term view of their investment strategy.
Commercial property investment options
The options that you have available to you as a commercial property investor differ somewhat from those who want to invest in the residential market. The three main ways to invest are:
- Direct investment – If you are looking to have full control over the property that you invest in then direct investment is the way to go. However, for most private investors this simply isn’t an option due to the amount of cost involved. Direct investment means that you would be buying the whole property, either by yourself or in a group, so the outlay can be vast. It is for this reason that the majority of investors choose a different route into the commercial property market.
- Direct commercial property funds – Often referred to as ‘bricks and mortar funds’ this option is a far more common way to get a foot in the commercial property door. These collective investment schemes invest on your behalf into a wide-ranging portfolio of commercial properties that would commonly be out of reach for most individual investors. Examples of which can include warehouses, supermarkets and office space.
- Indirect property funds – Another form of collective investment scheme, indirect property funds invest in property companies by buying shares that are listed on the stock market. This can sometimes fly in the face of the diversification process as this type of investment is closely tied to the rise and fall of the stock market itself.
Funds such as unit trusts, investment trusts and OEICs give the smaller investor the opportunity to be part of multi-million pound building projects that they would otherwise be unable to invest in. These funds normally operate in one of two ways: direct property ownership or by owning shares in property related companies.
Profits are paid to investors either by way of rental income and capital growth in the case of property ownership, or by the payment of dividends and growth in market value for shares in selected property related companies.
Many funds cater for very small investment amounts, some of which only require a lump sum of just £500 or monthly payments of £50 for those who wish to invest on a regular basis. This is what makes bricks and mortar funds ideal for those who are thinking of entering the commercial property market for the first time.
What drives profits?
As mentioned above, dealing in commercial property generally gives the investors two potential revenue streams: capital returns (a change in asset value) and income returns (money generated by the asset). Capital returns are determined by how well the overall property market is performing, whereas income returns depend upon the lease structure that has been signed off between the tenant and the owner.
Supply and demand naturally comes into play when investing in the property market. Strong demand from businesses that wish to rent property that you have invested in will obviously push prices upward and increase the overall rental yield. Strong demand will also mean that the owner will not have to incentivise businesses with offers such as rent-free periods, further strengthening the returns for the investor.
Good asset management will also help to push profits in the right direction. Rent reviews are typically made every five years where they are set to market level if that level has gone past what the tenant is already paying at the time of the review. Upward only reviews are common throughout the UK although there are other options available to the management team. These include:
- Turnover related rents – This is where the rent is set as a percentage of the occupying tenant’s business turnover made from the space they are renting. This type of rent is more volatile than the upward-only model, but it is a popular way of setting rent for the retail sector.
- Fixed uplift rents – As the name suggests, this type of rental agreement sees a fixed increase made to the rental amounts charged to the tenants after a certain period of time has elapsed, normally every three to five years.
- Index-linked rents – A somewhat new way of managing rental increases in the UK is the index-linked model. These agreements are linked in to indexes such as RPI inflation and increases to rental charges are made in line with the movement of said index.
What are the risks?
Dealing in commercial property does come with a certain amount of risk, much like any other investment. However, narrowing down the different risks associated with this sector is difficult as there are so many ways for an investor to enter the market.
For instance, the risk associated with direct investment will be entirely different to the risk you will have if you choose to put your money into an indirect property fund. The individual investors appetite for risk is also a factor, as some funds will offer greater risk for higher returns and vice versa.
Due diligence is key here. If you decide to enter into the commercial property market it is vitally important that you research each individual fund or property yourself so that you are fully aware of the risk involved with that particular investment.
2014 saw gains of 19% in the commercial property sector so it is little wonder that this form of investing is receiving greater attention of late. The UK economy is doing well and this naturally leads to more businesses looking for property to rent. The increased demand for commercial space means higher rental yields are easier to command.
If you are looking for a way to spread the risk of your investment portfolio, commercial property certainly offers up a viable way of doing so. However, research into your investment vehicle of choice is vital and it is advisable that you use commercial property as part of a wider investment strategy.
Commercial property investment may not be suitable for inexperienced investors, but for those with a little knowledge of the investment market it can prove to be a valuable addition to a well-managed portfolio.
Feature image credit: Jo.sau via Flickr
If you enjoyed this blog post then perhaps you’d like to read “5 Mistakes Property Investors Make“?