Investing in property - the risks

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.

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Risks involved

Location

  • The value, reputation and appeal of the location where your building is situated will fluctuate.
  • This could hold positive or negative consequences either way. If your building is situated in a particularly run down area that is soon to be regenerated, you may benefit from the ‘facelift’ as new visitors will be gravitating towards the area.
  • Alternatively, your business may be seen to be behind the times if the area is being regenerated and your shop/premises does not match up with the new aesthetic.

Characteristics of the building

  • The needs of clients will change over the years and as such will affect the value of your property.
  • The requirements of tenants as technology changes will affect the usability of your property. For example, if your building is not equipped with under-floor cabling, it may not attract tenants looking for an office building.
  • The overall design of the building will also influence a tenant’s decision to lease your building. If it looks outdated or particularly run-down compared to the buildings in the surrounding area, you may not attract as many prospective tenants. Furthermore, the materials used and layout of your building will be a factor that a tenant will take into consideration.

Tenants

  • A major factor in the value of a building is how much income it can gain for the owner.
  • If a tenants credit quality weakens materially the buildings sale value will suffer.

Length of lease

  • If a tenant has leased the property for an extended period of time, the resale value is generally safe. In contrast, if a tenant is set to move out whilst you are trying to sell, prospective buyers are less likely to want to commit time to filling your property.
  • If your tenant is considered unreliable buyers may be less likely to want to purchase your property.

Market cycles and risk

  • The property market responds to what is happening in the economy. The commercial property market can grow very fast leading to oversupply or grind to a halt leading to undersupply. It’s important to remember cycles will happen – growth periods will lead to oversupply resulting in market weakness, stabilisation will occur resulting in tenants occupying vacant space which will in turn lead to lack of premises to hire and so forth.

Market yield

  • Property value is determined by initial yield. Initial yield is the current rent per annum divided by the value of the property including any purchase costs.
  • The initial yield will fluctuate across the property market over time and will, as a general rule, reflect the general economic cycle.
  • Interest rates within the economy will also affect the average initial yield.
  • Any property investor will face the risk of initial yields rising which will cause property value to decrease – this may be due to rising interest rates or any other reason, however during a recession you may risk rise in premia. This can mean property yields could rise even if interest rates may not.

Risks by sector

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.

Rental growth

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.

  • Property value will change based on how the market expects your property’s rental income to increase, the same as how equity values will reflect expected growth in dividend income.
  • The expectations of rental growth will have an effect on the value of your property.
  • When investing in a property, your rental growth may not reflect what you initially anticipated, meaning your returns will also be lower than expected.
  • Many factors such as the national economy, lack of alternative space or vacancies, local trading conditions and other factors will affect your rental growth.

Product risk

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.

Diversify

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.

Beware of price volatility

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).

Geared investments

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.

  • What does your tenants credit look like
  • What is the length of their lease
  • Investment horizon
  • Term of the loan
  • What is the assumed rental growth

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.

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Other considerations to take into account

Fees and costs

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.

Initial fees

In the case of a close-ended fund, these initial fees will typically cover most of the set up costs. These fees may include:

  • Legal fees
  • Professional fees such as administration fees associated with setting up the fund
  • Marketing fees
  • Distribution fees
  • As well as commissions payable to advisors

Open-ended funds usually incur an initial charge that will cover distribution, marketing and promotion expenses.

Property acquisition costs

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.

Annual management fees

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 expenses

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.

Sale costs and exit fees

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.

Transaction fees

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.

Performance fees

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 advice.

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