Commercial property investment involves the purchase of buildings that are then let to companies for use as offices, factories, retail outlets or warehouses. The return on investment should derive from two sources. Firstly, rental income paid by any tenants may over the long run be the main source of returns. Secondly, the capital value should appreciate in the long run – though the gains are likely to be less significant than was assumed in the boom years.
Very few individuals have the money to invest directly in commercial property. However, even very small investors can access this asset class by pooling with other investors through a fund. Funds provide the additional advantages of diversification between several buildings, and tax efficient access to UK or European commercial property.
The global downturn of 2007-2009 challenged many previous assumptions concerning both commercial and residential property. Valuable lessons have been learned about the dangers of over-borrowing to invest in property and of investing too heavily in this asset class, at the expense of other investment options.
Advantages of commercial property
As an asset class, commercial property has the following advantages:
- It is typically less volatile than equities, but can provide returns almost as high.
- It is an excellent defence against inflation, because in the long run property values should rise if living expenses rise.
- The rental income provides significant stability of return, being more reliable than company dividends.
- It is perhaps the best way of linking investment to a region’s economic growth.
Disadvantages of commercial property
The disadvantages of investing in commercial property are:
- Commercial property is vulnerable to periodic bubbles and busts.
- It is vulnerable to economic downturns.
- The underlying costs can be high.
- Commercial property can be difficult to sell when values are falling, even when a fund is used.
Due to the potential difficulty in selling commercial property holdings, property is best used to diversify your portfolio rather than as a core portfolio holding. As a diversifier it can play a very useful role, given that the property cycle usually does not coincide with the cycle in equities. There are exceptions to this, however. For example, from 2007-2009 both commercial property prices and equity prices slumped in unison.
Return expectations from commercial property
There are two potential sources of investment return for commercial property. These are:
Capital growth: Capital growth refers simply to increases in the value of property. In the short run, capital growth tends to be positive in periods of good economic growth, lacklustre when growth is slow and negative in recessions. Just as economic forecasting tends to be an extremely unreliable science, property price forecasting is prone to unreliability and extreme differences of opinion.
In the long run there is good logical reason to think that property prices should keep pace with inflation. Sharper short-run gains and losses are very likely, but may eventually even themselves out.
Rental yield: In the long run, rental yield is likely to be a greater contributor to returns than capital growth, along with being considerably more reliable. In periods when rental yields are high compared to government bond yields, it may be a good time to buy commercial property.
In Ireland and the UK, leases tend to be long, commonly for 10 years or more at the outset. This means that the rental yield is effectively safe except in the event of tenant insolvency. Rents could of course fall at the end of the lease.
In a fund, overall rental yield is effectively a weighted average of the yield from the individual properties held.
Ireland, UK or Europe?
One of the harsher lessons learned in 2008-10 is that Ireland’s commercial property market is very small and very illiquid. There is also a reasonable argument that Irish investors are already exposed to Irish economic trends through their homes, jobs and pensions. For these reasons it may be advisable to look abroad for commercial property investment.
The UK market offers many of the advantages of the Irish market, such as a tendency for longer leases, with far more liquidity and diversification potential. However the UK operates a different currency and investors need to consider the danger of a fall in the value of sterling versus the euro. Many funds overcome this risk by purchasing insurance against movements in the value of sterling through currency hedging.
The European commercial property market may also offer opportunities. Leases in Europe tend to be shorter than in Ireland or the UK, meaning rental yields are less secure. However this has at times been compensated for with higher yields in Europe than in the UK or Ireland.
Gearing is a method of investment that involves borrowing for investment in order to boost returns. For example, an investor might put €10,000 in a geared property fund. The fund might then borrow a further €10,000 to increase the property exposure to €20,000 overall.
The reason that an investor may choose to use gearing is that it has the potential greatly to increase returns. Taking the example above, if the fund grows by 50%, the investor gets the gains on €20,000 invested rather than on €10,000. In simple terms, the investor will have gained €10,000, rather than the €5,000 he would have got from a non-geared investment.
However, gearing is high risk, and one should be well informed of the potential for high losses as well as for high returns. If a bad or just unfortunately timed investment is made, gearing can magnify losses. Suppose that in the above example the fund fell by 50%. Instead of losing €5,000 from a similar non-geared investment, the investor would lose €10,000, and effectively, his investment would be worth nothing.
The above examples are deliberately simplified. Whether the investment goes well or goes poorly, the fund will owe a bank interest on the loan. This reduces the excess return in good times and worsens the situation further if values fall.
There are stronger arguments for using gearing on property than on equities, because a stable rental yield may be used to deal with the interest portion of the loan more reliably than dividend yields could.
However gearing should only be used by medium-high or high risk investors, and even then gearing on anything more aggressive than a 1:1 basis should probably be avoided by non-professional investors. Where gearing is used, the property portion of a portfolio should probably be smaller than where gearing is not used.
The lessons of 2007-2009
Valuable lessons from the 2007-2009 property crash should be remembered, such as:
- Property should constitute part of an investment portfolio, not the whole of it.
- Buying two different properties, or investing in two different property funds, offers very limited diversification. The property market tends to rise and fall as a whole, and global economic trends can hit most property markets at once.
- The Irish property market is small and potentially very illiquid. It may boast very high returns in the good times, but it’s downturns may be exacerbated by its small size in the bad times.
- In extreme circumstances, gearing will make the effects of downturns very severe and much harder to recover from.
This does not mean property has no place in an investment portfolio and arguably the time to buy an asset class is when the market as a whole is very conscious of its dangers. It does mean that the same iron rule applies to property as for investments generally: where an asset class can deliver high returns, it can also deliver heavy losses.