Basics
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The basics of property investment
Successful investment in commercial property demands as much skill and expertise as investment in the stockmarket. Both require an assessment of the current and future condition of the economy and its potential impact on the company or property being considered for investment and an understanding of the risks involved. For example, if a sharp rise in short-term interest rates is expected, this may dampen consumer spending and reduce the investment appeal of shops and other retail property.
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Property categories
Commercial property is usually divided into three main categories:
Retail property – Retail is the largest sector and includes a broad range of property types, such as shopping centres, retail warehouses, high street shops, supermarkets and department stores. Retail property has been the best performer over the past three years [c], helped by buoyant consumer spending. More than 28% of UK retail investment property by value is concentrated in London and the south east.
Office property – Office property consists of standard office buildings and business parks, which have grown in popularity. Office space has been subject to the changing technology demands of tenants, e.g. for communications and computer cabling. Predictably, London dominates the office investment property market, alone accounting for 50% of the UK total. The south east accounts for almost another 20% [c].
Industrial property – This is the smallest category by value, covering industrial estates and distribution warehouses. The south east has the largest concentration by value of industrial property, with the North and Scotland coming second.
There are commercial properties that fall outside these three main categories – hotels, pubs and cinemas, for example, which are all in the leisure sector. The predictable income streams from some of these have been the focus of some innovative financing schemes in recent years.
Source: [c] Investment Property Databank 31-Jan-2005.
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Location, location, location
The expression may be a cliché but there is still a strong element of truth to it.
Location is one of the reasons why office space in London costs so much more to rent or buy than office space at the other end of the M4 in Swansea. The importance of location also explains why London and the south east are so dominant [d].
Location is a factor that can vary over time. Improved transport links can boost the value of property by making it more accessible to potential tenants and users. Not all improvements, however, are necessarily beneficial. For example, a new shopping centre may enhance an area, but it could also depress the values of existing high street shops nearby.
For the commercial property investor, the ideal location is one that is improving but has so far not attracted other investors' attention. Like investing in an undervalued company, however, the concept is easy to understand but execution is much more difficult.
It is essential for the investor to keep a constant eye on any changes that might affect a location's attractions.
Source: [d] Investment Property Databank 31-Jan-2005.
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Leases and tenants
Well-located properties with modern specifications should be re-let more quickly.
A lease is a contract between a landlord and a tenant that sets out the terms under which a tenant occupies a property. Once agreed the terms of a lease cannot be changed other than by mutual consent or as specified in the lease itself. Historically UK leases for commercial properties had terms of 25 years, but for a variety of reasons the average length has been falling for some time and is currently less than 15 years [e].
Most UK leases include provisions under which the rent is reviewed, usually every five years. The revised rent is negotiated between the landlord and tenant, taking account of new lettings, recent rent review agreements on similar properties and general market forces. If the two parties cannot agree on a new rent, it is referred to arbitration, which is binding on both sides. Most institutional leases say that at review the rent cannot fall below the current level. This 'upward only' review basis helps underpin the stability of income from commercial property.
When a lease reaches the end of its term, the tenant has the option to negotiate its renewal or walk away, leaving the landlord to re-let the property. If the tenant decides to move elsewhere, they will usually be required under the terms of the lease to reinstate the property to the condition in which it was originally let. The tenants may either complete the work themselves or make a 'dilapidations' payment to the landlord. In practice there are often a number of reasons why tenants renew their leases including the cost and disruption of relocating to new premises.
The financial strength of the tenant is a key factor in considering investment in a particular property. Upward only rent reviews are of no use if the tenant defaults. The tenant's ability to pay the rent – the tenant's covenant – is taken into account when acquiring, valuing and letting a property.
Tenants that are the least likely to stop paying rent – such as government departments – are favoured for obvious reasons. In a large property portfolio, however, some tenant failure is probably inevitable, which makes other fundamentals such as location, age, condition and specification all the more important. Well-located properties with modern specifications should re-let more quickly than poorly located, unrefurbished properties.
Source: [e] Investment Property Databank.
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Specification
Property needs to be suitable for the use to which it is put. This may sound obvious, but history shows that a building's usefulness can change markedly over time. The most obvious example of this is office space built in the 1960s and 1970s. This became unsuitable for many potential tenants because of its lack of air conditioning. Some of this redundant office space has since been converted to city centre residential accommodation.
A building with a good specification gives the tenant the ability to adapt to changes that occur over the lease period, which can be as long as 25 years. The flipside is that a poorly specified building may fail to find new tenants when the existing lease expires – and not all redundant commercial property lends itself to residential conversion.
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The government
The government is a major player in commercial property, both as an owner and as a tenant. It also takes an active interest in the operation of the property market, which it sees as important to the running of the economy. One area that has attracted the government's attention is the traditional UK lease with upward only rent reviews, which it regards as too rigid to cope with varying economic conditions.
Although no new legislation has been introduced, the government has threatened to do so if the UK property industry fails to introduce more flexible leases for new tenants. The property industry has introduced a new code of practice under which prospective tenants are offered a range of lease options.
Increased flexibility in leases is not necessarily all good news for tenants. As a general rule, the more flexibility enjoyed by the tenant, the higher is the rent to compensate for the greater uncertainty in cash flow for the landlord.
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Active management
Investment in property is not just a matter of making purchases then sitting back and collecting rents until the lease expires. To maximise returns, investors need to take an active approach to property management. For example, refurbishment, change of planning use and a renegotiation of lease terms can all add to the overall return from a property.
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