Commercial Property
Anthony Rommens
16-Mar-07
Business Angels may have had their curiosities sparked regarding investing in the Commercial property market. There has been news regarding the successful establishment of new Real Estate Income Trusts (REIT) that have been allowed in the United Kingdom since January 1, 2007. Increased competition for good properties and management difficulties for some investors in the residential Buy-to-Let market also may generate some interest in exploring Commercial property investments.
Commercial property is very different from Residential. Commercial property is Real Estate that is zoned for business which includes income producing property such as office buildings, petrol stations, restaurants, shopping centers, hotels and motels, parking lots and stores. Residential property is that which is zoned for people’s more permanent living such as singlefamily homes, town homes, flats, and council estates.
Residential Buy-to-Let has prospered over the last ten years as house prices, mortgage availability and property size has attracted many investors. There are big differences in Commercial vs. Residential property investments. Commercial property tends to be much higher priced than Residential and this proves to be a great barrier to entry when investing. Residential Buy-to-Let tenants tend to have short leases compared to commercial which might be for a decade or longer. Residential landlords are responsible for repairs where as commercial tenants are responsible for upkeep. Return on Residential investment is largely derived from property value increases where in Commercial property, it is derived from rental income.
Investment in Commercial property can offer a secure and stable inflow of rent money. Commercial property tends to be less volatile than other assets. Compared to other investment types such as cash, equities and government bonds, commercial property tends to provide high yields provided that inflation remains low. Overall, Commercial investing has recently performed at slightly lower levels than equity investments. Over the previous ten years, the income return on commercial property has remained stable unlike bonds and equities. Over longer periods of twenty five to thirty years, Commercial property has generally produced returns greater than that of cash or bond deposits. Investing in commercial property offers additional diversification to an investor’s portfolio as equities and bonds tend to both follow the same patterns and tend to correlate with one another. Property offers the investor a tangible asset. Investors can actually see their investments and this may offer a psychological value. However, commercial property needs to be managed and there are substantial expenses to maintaining such investments. The estimated size of the Commercial property market in the United Kingdom is approximately £763 Billion while the UK residential property market is about 4.5 times larger. Equities on the London Stock Exchange are valued at 2.3 times that of total Commercial property.
About 80 percent of the commercial property market is made up of industrial, office and retail stores. Approximately half of these are owned by business, non profit or government organisations that occupy. The other half of commercial properties are known as investment property. Investment property is rented to a tenant by an owner landlord. Companies and government organisations increasingly sell their property to obtain capital and then lease back their space to new owners. Thus the proportion of overall available investment property is growing over time.
The other 20% of total commercial property would be made up of leisure parks, pubs, hotels, student accommodation and healthcare properties.
Most commercial property is located in London and the Southeast. Retail is more evenly spread all over the UK than industrial and office property. There are a variety of players that make up the UK Commercial property market:
INSTITUTIONAL INVESTORS (40%)
The largest holders are financial institutions. Pension and insurance companies own about 28% of direct commercial property. They also have about 15% of indirect commercial property through pooled funds, property trusts and partnership investments. Indirect investment has grown considerably over the last five years. Limited partnerships are currently the most popular choice for many investors who want an indirect way to invest. These partnerships are tax efficient and are professionally managed with the ability to focus on specific market sectors. Limited partnerships also allow debt financing and this is attractive for institutions, however recent legislative changes have made Offshore Unit Trusts more attractive than limited partnerships.
PROPERTY COMPANIES (30%)
There are well over 3,300 Private Property companies that range from owning one property to many. Bankers provide financing largely for private property companies. Commercial property developers find and create commercial property. They obtain financing from various commercial players, joint company ventures, institutions and banks. They can be risky investments but rewards can be substantial. Large property companies on the stock exchange account for at least 14% of commercial investment property. These are likely to be reduced over time because of the introduction of Real Estate Investment Trusts (REIT). REITs have been long established in other countries and are just now legal entities in the UK. REITs are new corporate organisations that efficiently avoid taxes on both Residential & Commercial property investments.
FOREIGN (15%)
Foreign investors have purchased significant amounts of property in the United Kingdom. The UK offers good historical performance relative to financing costs. Recent Irish investment has been high at about a quarter of all out of country investments. Perhaps the main reasons are close proximity and familiar property laws. Overseas investment can also come from wealthy individuals and corporations seeking to diversity their risks by investing outside native countries.
CHARITIES & ESTATES (5%)
Traditional large estates like Church and Crown, Cadogan, Grosvenor and Portland, along with charities and related trusts, make up 5% of the investment property market. Charities increasingly make use of Offshore Property Unit trusts.
HIGH NET WORTH INDIVIDUALS (3%)
Business Angels could be considered in this category. Unpredictability in equities has created interest in commercial property investments. Barriers to entry exist as substantial capital investment is often required. As a result most Business Angels have stayed with residential Buy-to-Let investments. Institutions have developed commercial investments specific to wealthy individuals so that they can invest easier in the commercial field. These require investment sizes that can range from a few thousand pounds to over several hundred thousand pounds depending on the type. Expect to see even more affordable commercial property investment products in the future.
Residential REITs (not yet announced) may be of particular interest and an opportunity as many high-net-worth investors are experienced and thoroughly understand this business.
OTHER PLAYERS (7%)
A variety of other property players that include individuals, consultants, developers, corporate structures, and financial organisations.
HOW THE MARKET WORKS
Business has been primarily performed by agents who match buyers and sellers in commercial buildings. Property sellers contract a sales agent to market property. Buyers must recognise the sales agent who introduces the property to them and then the agent is usually retained in order to assist with the purchase or the purchaser simply pays an introduction fee. Using the internet, agents can list properties for owners using various property websites.
Auction companies also sell commercial property directly for sellers. The auction market has grown steadily over the last half decade mainly due to private investors seeking property. Some investors complain that the big problem with commercial property is that it is not easily sold. However, it has been reported by the Investment Property Databank that the average holding period for commercial property is actually about seven years. When comparing to the liquidation of bonds and equities, commercial property is still difficult. Commercial property does take months to market and it actually takes some time to close a sales contract. It tends to be more expensive to execute than other long term investments. Investors definitely need to consider the extra time and expenses.
Commercial property includes costs that other investments do not incur. One average, it costs 1.8% for agent’s advice and legal transaction fees (also there can be fees for valuation, engineering inspections, surveys, environment audits, applicable VATs). Buyers must also pay Stamp Duty Land Tax (SDLT) on commercial transactions. This land transfer tax varies according to the selling price. It is 1% for properties between £120,000- £250,000. SDLT is 3% for £250,000 - £500,000 and 4% on commercial property prices over £500,000.
The property markets require valuations because sale prices are not announced to the general public. Valuations are thus derived from RISC Appraisal and Valuation Standards (“The Red Book”) from the Royal Institution of Chartered Surveyors and this manual outlines the UK standards for valuating commercial property. It must be noted that the valuation of property often differs from the actual sales price. This is caused by a number of factors that deal with the imperfect nature of market information.
The standard upon which to measure investment performance return is known as Market Yield. It is calculated as the annual rent divided by the property value. For example, if a property’s yearly rental income is 1 million pounds and its value including purchasing costs is 12.5 Million pounds then its market yield would be 8%.
In the UK, investors should look at property indexes to compare returns. Most indexes are produced by the Investment Property Databank. These measure performances based on a wide range of company portfolio valuations rather than actual transaction data. Various commercial property index measurements may be found in the Companies & Markets section of the Financial Times.
Commercial property investing is more complex than other asset classes. Private investors have become a growing force in the market despite the fact that commercial investment requires large amounts of capital. Some investors pool their money together in order to form syndicates in which to purchase property. Investors might also invest in limited partnerships that can be leveraged but are not usually very liquid. It is worth noting that only specialists may wish to venture into such arrangements. There can be significant risk involved as the investments might not be suitably diversified or managed. Independent advisors are necessary to fully understand the entire consideration of risk.
Self Invested Personal Pensions or SIPP can be used for direct commercial property investments. A SIPP can even be used to invest in a commercial property that is occupied by the small business owner / investor. Rent must be paid at market prices. This type of arrangement is done according to strict criteria. Risk might not be diversified enough in this specific situation so advisors are recommended to be used here as well.
Property Companies (including those offshore) that are listed on the exchange have shares that may be bought and sold by investors. Stock prices change much more than the value of property assets so performance tends to be more aligned with that of the stock market rather than the commercial property market. These investments are not very tax efficient and many listed companies are now forming into Real Estate Investment Trusts.
Investment Trusts, not to be confused with REITs can also be bought through the stock exchange but they usually invest more in residential property.
REITs are corporate structures that purchase, sell, own and manage income producing property (both residential and commercial). They pay out most of their income to shareholders through dividend or property income distribution (PID) payouts. As a result, they are largely exempt from corporate tax.
New 2007 legislation has allowed for REITs in the United Kingdom. There are specific conditions for a property company to qualify as a REIT. The main ones are that they are UK based, listed on the London Stock Exchange (recognised by the Financial Services Authority), and are a close-ended investment trust. So far the largest UK property companies have, or are in the process of converting into REITs. They are expected to form into a significant sector of commercial property.
REITs are very tax efficient. They are not taxed on either income or capital gains. Profits go to shareholders free of tax. Shareholders are then taxed individually. This is in contrast to a regular property company which is double taxed on Corporation profits from rental income and property sales (Capital Gains). Investors can directly invest in a REIT by owning shares or indirectly invest by holding some other financial investment that has interest in a REIT.
Examples of these new REITs are British Land, Hammerson, Land Securities, Liberty International and Slough Estates. Other types of commercial property investments are; authorised and unauthorised property unit trusts, unit-linked pension funds, UK life bonds (life insurance) and derivatives. The growing number of investment vehicles have many fees. There are many significant costs to consider besides general management. Fees can include; professional startup, property acquisition, extra management fees, property management expenses, sales costs, exit fees, transaction fees, performance fees, and varying taxes. Investors therefore must do comparisons and evaluate what is best for their particular situation.
Investing in commercial property can generate good returns but all investing options involve variable elements of risk and intensive fee and tax assessment. Comparing investments in detail with the help of tax and legal advisors is necessary. This should however be nothing new for Business Angels who are used to performing detailed research for their various entrepreneurial investments.
