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If you are thinking of investing in commercial property for your business, it’s important you’re aware of the risks involved. There are many benefits to owning your own property for commercial purposes, but there are also many pitfalls to be mindful of before investing.
This is an indicative guide, it is important to seek advice from an Independent Financial Advisor. Through our network of advisors we are able to put you in contact with a professional in this field.
Market cycles and risk
Every property is part of a business sector, an example being a shop, warehouse or office. Property sectors perform differently from the property market in general, the same way business sectors in the economy behave differently.
For example, in 2007 the return on average for the property market collectively was -3.4%. During this year offices were outperforming, showing a -0.5% return where shops generated -6.1%. Of course these are just averages as some shops will have performed better than some offices, but the sector effects are plain to see. It is a good practice to spread your holdings across different sectors so you essentially reduce the risk of being hit by economic decline in a single sector.
You can find the value of any financial asset by discerning the discounted value of its future income stream. The income stream comes as dividends in equities, whereas in property, it comes as rent.
If you invest in commercial property through a vehicle such as a unit trust or fund, this usually helps to reduce the risks inherent in investing, but there are still risks involved using these structures.
Liquidity will depend on the time needed when transacting a sale and how easy it will be to trade at the market price.
It’s important to remember that direct property investments are seen as relatively illiquid compared to most equities and bonds.
Even in normal commercial market conditions it is slow to transact property, and in the case of an economic downturn or poor market, it can be very difficult to find a buyer especially at the right price.
As far as indirect investments go, open-ended investment companies (OIECs), listed property company shares and real estate investment trusts (REITs) are classed as the most liquid.
Due to the fact they are equities listed on public stock exchanges and are priced in real time, they can be traded quickly in normal market conditions.
There is only a small amount of secondary trading with indirect property investments to do with unit trusts and funds, yet these indirect investments are classed as more liquid than other properties due to the fact the fund manager will be able to accommodate and transact small sales easily.
It’s important to remember that a fund manager may need you to wait several months if you need to get your money back, if a large amount of investors want to sell at the same time or if the sale takes place in a difficult market.
In contrast some unit-linked property funds have now stopped accepting new investment where they have received large amounts of cash from investors and have been unable to secure or purchase the suitable assets required.
Although institutional fund managers currently dominate trading, other parties including HSBC make a secondary market in property unit trust. There have only been a handful of secondary transactions as interests in limited partnerships trade infrequently. As a rule of thumb managers will try to match buyers with sellers but you should never assume a suitable match will be easily made.
We recommend that you invest in a fund that has many properties in its portfolio as there is less risk involved than that associated with a fund responsible for a single property. You also reduce risk by investing across different sectors and geographical areas.
By investing in listed property companies and real estate investment trusts (REITs) as well as other quoted property vehicles you help reduce risk by diversification. Their shares will also offer liquidity as they are equities, but these shares will be more volatile due to real-time market pricing and changes in investor sentiment. These companies may also trade at a discount to net asset value (NAV).
Put simply, gearing is the use of debt. Limited partnerships and unit trusts are classified as geared vehicles and although they can expose investors to more risk they can potentially reap higher returns - as long as the gearing level is at 70 per cent or higher. Gearing measures the relationship between equity and debt in your investment.
If there is a high proportion of debt to equity this is known as a highly geared investment. There is an inherent risk involved with high geared investments as there is more chance that the investment will not gain enough income required to pay off the debt.
The risk is higher if your geared vehicle is invested in one property, but could be reduced if you have a reliable and high quality tenant as this would reduce the risk of default on the income stream from rent that you have used to secure the loan.
It’s important to consider these points when you are assessing the risk involved in a geared vehicle.
Remember, your investment will come into difficulty if your tenant stops paying rent, and before your vehicle could re let the building you would almost certainly default on the loan payments meaning your investors would lose money and possibly a large part of their capital. Tenant default is not terminal for an ungeared vehicle.
Property funds will charge fees, as will other collective investments. In the case of property funds a wider range of fees are involved. You may find that these fees are covered by the annual management fee or the initial fee. We’ve outlined the seven categories these fees fall into.
In the case of a close-ended fund, these initial fees will typically cover most of the set up costs. These fees may include:
Open-ended funds usually incur an initial charge that will cover distribution, marketing and promotion expenses.
The fee quoted for a property will not always include all the costs involved in buying that property. Property sales will usually include a stamp duty land tax VAT. There will also be fees associated with solicitors, agents and specialist surveys.
In regards to open-ended products, the cost of the investment will normally take into account any of the fees associated with buying the property but may also show an initial charge.
An annual management charge will normally refer to any yearly expenses associated with the on-going running of the fund. In most cases, this charge is levied as a percentage of the gross assets of a fund.
We would advise that you check as to whether there is a separate property management charge or if this is already included in the annual management charge.
In the case of an offshore property investment company, there may be a fee for directors and administration, this is also the case regarding offshore property unit trusts and trustees. These fees may or may not be included in the annual management fee.
Property management is far more labour intensive than the management of paper investments such as equities or bonds. Duties can involve the collecting of rent, rent inspections, re-letting and letting of properties, rent reviews, insurance arrangements and so forth. The fund will pay these property management expenses. These property funds will require valuations from time to time, and the fees involved will also be charged to the fund.
Any costs incurred when selling off a fund’s assets are usually paid by the investors and can be considerably large with the current rate averaging 1.5 per cent of the sale price. Funds may also include what is known as an exit fee which is paid upon the sale of the underlying property assets. It’s worth noting that these fees are payable no matter the performance of the fund.
In regards to open ended funds the price at which units may be redeemed will usually be respective of the costs and expenses of selling the fund’s assets.
Open-ended funds including diversified ones will typically buy and sell properties over time as fund managers evolve their property portfolio and take advantage of market trends. The associated costs known as ‘round trip’ costs usually rank at 6.75 per cent to 7.75 per cent and can seriously dent short-term performance.
On occasion funds will operate as a trader, which means any costs associated with the buying and selling of assets will be covered by the fund. Any offshore based, UK listed property investment companies will fall into this category.
Fund managers and sponsors may be paid a performance related fee if they reach a pre-determined target, this is in addition to any of the fees and costs as highlighted above. These performance fees may be paid during the life of the fund, or on termination.
If you require any more information on the risks involved in commercial property investment or advice on purchasing commercial property contact our expert advisors today for free initial guidance on your options.
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