- 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 If it looks outdated or particularly run-down compared to the buildings in the surrounding area, you may not attract as many prospective tenants.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.
- 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.
- 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.
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.
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.
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).
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.