Asset classes explained
Commercial property investment explained
By Michael Trudeau
Article 3 of 4
Commercial property investment explained
We explore the benefits and pitfalls of commercial property investment.
Why invest in commercial property
Buying a house not only puts a roof over your head and provides financial security over the long term, but it can also be a good way to invest your money.
However, it is not completely safe. For example, the financial crisis in 2007 saw many property investors to get their fingers burnt, illustrating that investing in property is not without risk.
Commercial property is an important asset class to consider as a way of spreading, or diversifying, risk in your investment portfolio. Generally, property isn't highly correlated to other assets classes such as cash, fixed income (bonds and gilts) and equities, meaning that property values move independently of other assets and aren't typically affected by what's going on in the stock markets.
Find out more: Which? investment portfolios – we have created a unique set of investment portfolios that can help you decide on the right mix of assets for you
Investing in commercial property – the options
There are a number of different ways to get exposure to property as an investment:
- Direct investment: for private investors, direct investment in property means literally buying all of, or a share in, a property. For most people, this is not a practical way of getting exposure to the commercial property market.
- Direct commercial property funds: also referred to as bricks-and-mortar funds, these are a more common way to invest in commercial property, via a collective investment scheme, such as a unit trust, Oeic or investment trust. These invest directly into a portfolio of commercial properties, such as supermarkets, offices and warehouses, which are otherwise inaccessible to smaller investors.
- Indirect property funds: these are collective investment schemes that invest in the shares of property companies that are listed on the stock market. They do not have the same benefits of diversification as direct investment in property – as property shares can move up and down with stock markets.
Find out more: Different types of investment – learn more about different investment products and how to benefit from them
There are two principal ways for you to earn money from a commercial property investment:
- income from renting to a tenant
- capital growth from an increase in the value of the property.
Many private investors already own their own home, so the process of buying another property may seem a more familiar and straightforward proposition than investing in the stock market. However, a buy-to-let property investment is not without risks.
Most investors in residential property will need to borrow in order to get their foot on the buy-to-let ladder. Here are some key points that you need to keep in mind about buy-to-let mortgages:
- You'll need a much higher deposit – generally between 20% and 40% of the value of the property – to get a buy-to-let mortgage.
- Expect to pay higher interest. This is because there's more risk for the lender – your tenants may not pay their rent or you may have periods when the property is empty, meaning no rental income
- Your mortgage charges will be higher, as you often 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.
Buy-to-let property and rental yield
This is an important figure to have in your mind if you're thinking of buying a property as an investment. The rental yield gives you an indication of what kind of return you'll be getting from the property.
The rental yield is quite simple to calculate, but you need to be fully aware of all of the costs you may encounter when you become a landlord. By far the biggest cost to you will be your mortgage, but there are others fees to consider, including (but not limited to):
- buildings insurance
- maintenance costs
- ground rent and charges
- letting agency fees.
Once you have deducted all of 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.
So if you own a property worth £250,000 and the net rental income is £12,500, your rental yield is:
- £12,500 / £250,000 = 0.05, or 5% per year
Need mortgage advice?
The Which? Group offers an independent mortgage advice service, Which? Mortgage Advisers, that looks at every mortgage from every available lender. You can call the service on 0808 252 7987.
Investing in commercial property
Many property investors prefer the familiarity of investing directly in residential property, but commercial property can offer a simpler and lower-cost alternative.
Commercial properties cost millions of pounds to purchase or build and can command huge rental incomes but, in most cases, they're impossible for smaller investors to buy outright. Therefore, most invest in commercial property through investment funds, like unit trusts, Oeics or investment trusts. You can find out more about these products in our different types of investment guide.
These funds 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.
You usually only need around £500 to invest a lump sum in a property fund, or £50 per month for regular savings.
There are three categories of commercial property:
- retail property – including shopping centres, supermarkets, retail warehouses and high street shops
- office property – purpose-built for businesses, these often require installation of high-speed internet and other services essential to businesses
- industrial property – such as industrial estates and warehouses.
Why could commercial property be a good investment?
The UK benefits greatly from a longer lease structure compared with Europe and the US. 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.
This is much longer than what you would get from a residential property, which generally has leases of six months to a year.
This structure potentially offers more security relative to the returns offered by shares, as income is guaranteed at a set level for an extended period of time.
Commercial property funds
There are two different types of commercial property funds within which you can invest. They both come with different benefits and risks.
Direct or 'bricks-and-mortar' commercial property funds
Bricks-and-mortar funds refer to direct commercial property investment, meaning that actual physical properties are bought by the fund. Risk is spread across a number of different properties and, therefore, if one property is not occupied (and therefore earning no income from rent), 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. Rental income provides you with an annual return and, when you cash in your investment, you'll hopefully receive the sum you initially invested, plus any growth in value of the properties within the fund.
Benefits and risks of direct commercial property investment funds
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.
Beware the lock-out of direct commercial property investment funds
When the financial crisis rocked the economy, a large number of direct property fund investors found they could not take their money out as property values plunged. This was because property funds have a little-known clause that allows fund managers to shut off payments to investors wanting to exit the funds if there are "exceptional circumstances."
Under Financial Conduct Authority rules, property funds can suspend trading for 28 days while they try to raise enough cash by selling properties to meet the repayments of investors looking to reclaim their cash. This 28-day period can recur until the fund has enough capital to meet redemptions, and during the financial crisis of 2007/08, some of the moratoria on people leaving funds lasted as long as 12 months.
Fund managers argued this was for the benefit of investors, as a fire sale of properties in such conditions would mean they would not be able to realise their full value.
Indirect commercial property funds
These funds, usually in the form of unit trusts and Oeics, buy shares in companies that invest in property. These shares are listed on the stock exchange and traded on a daily basis; therefore, they don't have the liquidity problems of direct commercial property funds, meaning you can move in and out of the fund freely.
Returns are gained like any other investment in shares, through share-price appreciation and dividend income, rather than directly through property price increases and rental income. But while you get the benefit of the liquidity of an equity-like product, you also get the volatility of investing on the stock market.
Find out more: Investing in equities – find out more about investing in stocks and shares
Real estate investment trusts
The great majority (over 80%) of these property companies are known as Real Estate Investment Trusts (REITs) and have greater tax benefits than other listed property companies.
REIT companies don't pay corporation tax on their assets on the condition that 90% of profits are paid to shareholders as dividends, which, in turn, could mean higher payouts. REIT investors pay either 20% or 40% tax, because they're classed as property-letting income.
Property investment trusts
Alternatively, you could invest in property investment trusts, which will pool your money to buy property and property company shares. The difference between these and REITs is that they're considered to be like any other company, so tax on dividends from the 2016-17 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 respectively.
Investment trusts can do things that unit trusts and OEICs can’t. For example, many property investment trusts use gearing – a process whereby the companies borrow money – to boost the amount they can put into property beyond what you have invested. While this can enhance gains in a rising market, it can magnify losses if returns fall.
- Last updated: November 2017
- Updated by: Michael Trudeau