Commercial Property Ripe for Picking?

Commercial property fund sales have started to make a comeback after a couple of very difficult years. Is this renewed interest founded on solid rock or sinking sand?.

Let’s start with a quick recap. Commercial property funds are available in two flavours: those that invest in physical properties and those that buy shares in companies whose business is to invest in property. Physical (or ‘direct’) property funds have tended to be most popular with private investors and offer a more exposure to the market, so we’ll focus on those.

Direct property offers two ways to make money: rental income and increases in the price of property. Unlike residential property the rental agreements on commercial buildings (e.g. offices, factories and shops) tend to be very long term, typically 10 – 25 years. This means that income should be steady provided the tenants continue to pay their rent and don’t move out during the lease leaving the property vacant. Commercial property prices have historically tended to be more stable than residential prices (less so recently!), but they do still vary and you can lose money.

The sector had been chugging along quite happily for a few years until mid to late 2007, when declining economic fortunes started hitting commercial property prices. This continued through 2008 to mid 2009. According to the IPD UK Annual Property Index (which measures these things) during 2008 UK commercial property prices fell by an average 26.3% while the income return was 5.6%.

Rental income has been hit, largely due to vacant space and downward pressure on rents charged on new agreements, but the proportionately bigger fall in prices means that yields (income / price) currently look attractive at an average of around 7% (they’ll be less on funds due to charges).

Prices also appear to have stabilised over the last few months (for now at least), seemingly due to improved economic optimism and a weak Pound making UK property rents very attractive to foreigners.

So, on the surface, it looks like quite a sensible time to be buying into the sector. If things remain stable, which you might argue is a big if, then rental income should be steady and you might even make a bit of money from rising prices over the next few years.

The downside is that if our economy deteriorates further there could be more downward pressure on rental income and prices will likely be hit, meaning you could lose money.

If you’re looking to invest in a direct property unit trust then a few important things to consider.

1.Up to 10% of your initial investment could be swallowed up by charges and tax. Initial fund charges are around 5% and the fund must pay 4% stamp duty when buying properties plus agent’s commissions and legal expenses etc. These costs are usually reflected in the buying price of the units. They are, to an extent, potentially avoidable. You can reduce or avoid initial charges by using a discount broker and, when you come to sell, if there are more buyers than sellers a fund manager might buy back your units including the stamp duty costs as they can effectively be passed straight to a waiting buyer.

2.There’s a risk you won’t be able to get your money out when you need it. Unlike stockmarket funds, direct property funds can’t simply sell some of their assets (i.e. a property) every time they need to pay back an investor who wants to sell. Because of this they must hold some cash (and quite often a few property shares too), called ‘liquidity’. But if so many investors want to sell that there’s not enough liquidity to pay them all, the fund will likely close its doors to withdrawals until it can sell some property to fund them. This could take several months or more and in a depressed market the prices they achieve could be poor, reducing your ultimate investment return. Always look for funds with reasonable liquidity (15 – 20%).

3.Does the annual management charge come from income or capital? If the manager takes their fees from rental income, then while this reduces the fund’s yield it’ll avoid them eating into your underlying investment.
Whether investing now is worthwhile really depends on your views for the economy. I’m a little pessimistic but there’s plenty who’d disagree. At least the bubble of two years ago has burst, so if the downturn persists there’s probably less far for the commercial property market to fall.