Assessing the asset class: Commercial

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Commercial property plays an important role in the portfolio of many wealthy investors. Among the wealthiest survey respondents, who have more than £30m in financial assets, 70 per cent have some exposure to direct commercial property investments.

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According to some interviewees, the commercial property market in some countries is currently looking attractive. “I think it may be a good time to buy commercial property which is prime – well located, good quality and let to tenants with good covenants on long leases,” says Charles Beer, a Senior Partner in Real Estate Tax at KPMG in the UK. “Supplies of such property are very limited, however.”

The commercial property market is very different from the residential market. For one thing, the investment sizes are substantially larger; it is hard to get a foothold in the market for much less than £5m, according to Sean Brew, Head of Portfolio Asset Management at global real estate adviser DTZ. In addition, it is in many respects considerably more sophisticated. Aside from ultra high net worth individuals, buyers tend to be institutional funds or corporate buyers, who will research investments very carefully and manage their portfolios on a continuous basis. To compete in this market, individual investors need to adopt a highly professional approach.

“In my experience, private investors in commercial property as a group are highly entrepreneurial,” says Mr Brew. “They are risk-takers and they know what they want. They are very proactive.”

The main advantage of investment in commercial property, according to respondents, is the yield that can be obtained through rental. With many other assets yielding relatively low returns as a result of record low interest rates, the returns from commercial property can look attractive. Certainly, yields on commercial property are higher than in residential, because businesses are prepared to pay more for space in a good location that helps them to achieve their goals. This makes commercial property more suitable for generating income, but some experts caution against high expectations.

With unemployment still rising, vacancy rates on commercial property remains high, which means that there is a risk that the investment will yield no income at all.

 

“Commercial property is now providing good value and, when people look at returns from other investments, yields look attractive,” says Ian McBryde, Director of Property Funds at F&C REIT. “However, people need to be reminded that some of the underlying fundamentals such as tenant demand and vacancy rates are still not strong.”

With unemployment still rising, vacancy rates on commercial property remain high - for example, the void rate in the UK is now at an all-time high – which means that there is a risk that the investment will yield no income at all. And investors should be aware that downturns in commercial property can last for years, rather than months. This is because commercial properties take several years to develop, which can lead to a significant lag between supply and demand.

 

 

 

Which of the following factors do you consider to be most attractive about holding commercial property investments in your portfolio?

 

“I am less optimistic about commercial property in general, at least from an equity perspective,” says Basil Demeroutis, Partner at Capricorn Investment Group. “I think there are some huge unresolved problems overhanging the sector that I don’t think anyone is dealing with – it will take time and money to put this right. It’s fine if you can find well-let buildings in the West End or Times Square with good tenants, but there is a limited supply of properties like this.”

Mark Carpenter, Director of the Property Team at Henderson New Star, a fund manager, is more optimistic about some markets’ ability to recover quickly. “Some markets are bouncing back quickly while some are still experiencing severe problems,” he says. “The UK was the first to drop, in Q2 2007, while some in the Far East and better quality properties in Western Europe didn’t experience falls until at least 12 months later. And as there was a time lag on the way down, we thought there would be a mirror in the recovery. But other areas are showing faster improvement than the UK.”

Mr Carpenter is particularly bullish on the Far East, partly due to a change in demand. “These are still growth economies, even though the growth has slowed,” he says. “In Q4 2008, after Lehman’s bankruptcy, yields were hit by 200 basis points and international demand dried up, led by the North Americans and Europeans. However they are now being replaced by local wealthy individuals and corporates, who are not very leveraged. It’s an interesting change with the local players becoming the drivers and nudging prices up.”

Choosing the right investment vehicle

 

Diversification remains important in commercial property but it can be difficult to achieve through physical holdings due to the large sums of money involved, except for the very wealthiest investors. But the growth of property funds allows investors to achieve diversification across multiple types of property and location with smaller investments, and to gain access to the expertise of specialist managers. “In order to get the kind of diversification that we think property as an asset class needs, and not get tied to some very specific risks, it’s crucial for investors to pool their money in some kind of fund structure to buy a larger, more diversified pool of assets,” says Rory Gilbert, Director of the UK Private Bank at Barclays.

 

Which of the following types of property investment do you hold in your portfolio?

 

Among our survey respondents, 29 per cent say that they hold indirect property investments such as mutual funds and real estate investment trusts. However, there are wide variations in indirect holdings amongst the target countries. Investors in Monaco are most likely to invest in property indirectly, with 61 per cent having holdings. Investors in the US (48 per cent), Canada (41 per cent), Singapore (45 per cent) and Hong Kong (42 per cent) also favour indirect investments, while the UK and GCC are lukewarm, with just 17 per cent having indirect property investments. Spanish investors are the least likely to invest indirectly, with just 3 per cent having these holdings.

The survey also found that the wealthiest respondents are the most likely to invest directly.

The survey also found that the wealthiest respondents – those who in theory are most able to make direct investments in commercial property – are the most likely to invest indirectly. Almost 45 per cent of respondents with investable assets in excess of £30m hold indirect investments while just 26 per cent of respondents with £500,000 to £1m invest indirectly. This may be due to better quality advice received by the wealthiest or it may be due to the fact that the wealthiest will have more investments – they are also the most likely to hold direct commercial property, with 70 per cent of respondents with assets in excess of £30m holding directly while just 17 per cent of respondents with £500,000 to £1m have direct exposure.

There is also an interesting divide between the sexes. While 33.7 per cent of male survey respondents hold indirect property investments, just 14.2 per cent of female respondents do.

 

Which of the following types of property investment do you hold in your portfolio?

 

While property funds offer a lower entry point for investment in commercial property and diversification, they are not without their problems. Their liquidity is often cited as an advantage – it is much easier to get out of a mutual fund than sell a property – but investors need to read the small print and understand each fund’s rules on redemptions.

For example, UK investors were caught out in late 2007 and early 2008 when some property funds were forced to suspend redemptions, and sometimes trading entirely, as a result of lack of liquidity. Most funds tended to keep between 5 per cent and 10 per cent in cash in order to meet investor redemptions, but when a wave of investors decided they wanted out, the funds were unable to cope, shrinking cash levels significantly and forcing the sale of property. “It was a psychological thing – people panicked,” says Mr McBryde. “At the time, it was like a run on a bank but most retail funds are now stable and seeing positive inflows.”

Problems such as these have led investors to question which type of fund structure is best suited for property investment. Open-ended funds, at the end of every day, issue shares to new investors and buy back shares from investors wishing to leave the fund – with inflows and outflows often cancelling each other out. But when outflows greatly exceed inflows, and the cash cushions funds keep are depleted, there are problems.

This has led some investors to prefer closed-ended vehicles, such as property trusts or REITs. These funds have a set number of shares so, once they are all in circulation, investors must purchase them on the secondary market rather than from the fund manager, and shares are not normally redeemable for cash or securities until the fund liquidates. This means that the fund manager is not forced to sell property in order to meet redemptions, and investors may sell their shares at any time – provided they can find a buyer, that is. However listed trusts and REITs are more correlated to equities than direct property investments or open-ended funds, because they are also traded on the stock market.

The key is for investors to know what they are buying and for property managers to be clear in their communications. “Institutional investors understand that property is a long-term investment and that transactions are expensive and take time,” says Mark Meiklejon, Investment Director at Standard Life Investments. “But this can be a problem in the retail investment space if they don’t understand that direct property is illiquid. This has raised issues with some managers around how they communicate this to investors.”