How to invest in commercial property: a beginner's guide

Britain is a nation of property lovers. But rather than buying a residential property, how about investing in commercial property?

The asset class hasn't always had an easy ride. In 2008, commercial property prices fell by an unprecedented 44 per cent almost overnight, as the US sub-prime mortgage crisis resonated around the globe.

Since 2007, the market has gradually got itself back on its feet, and over recent years it has become an increasingly attractive investment. In 2013, 2014 and 2015, investment returns from commercial property were 10 per cent plus.

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Investors have piled in, attracted by the sector's hot streak. But there is another reason behind the sales surge - portfolio diversification. Commercial property returns are relatively uncorrelated with those from equities and bonds, which helps make portfolios less volatile overall. There is also the attraction of a relatively safe source of steady income.

THE BASICS

The commercial property market is made up primarily of shops, industrial buildings such as warehouses, and offices.

You can typically invest directly, by buying a fund which holds actual physical property in its portfolio or by buying a property yourself; or indirectly, by investing in property companies, developers and housebuilders, or in funds invested in those companies.

As mentioned above, investment funds and trusts providing exposure to the sector are divided into two types. A traditional bricks and mortar fund will invest in the property directly and be structured as either an open-ended fund or a closed-ended investment trust.

It will physically buy the property and be responsible for its maintenance and rent collection, and have the added benefit of a regular rental income which typically rises in line with inflation. However, as offices and warehouses are not easily bought or sold, such funds can be very illiquid.

Bricks and mortar traditionally has little correlation with equities and bonds, so in times of volatility direct investments in commercial property in particular can help to preserve wealth.

According to experts, the only time there is a correlation is when property rents are falling.

Property securities funds invest in the shares of listed property companies and so are far more liquid, but are exposed to the ups and downs of the stock market.

Investors can also buy shares directly in a Reit (real estate investment trust) such as Land Securities or British Land, which runs a portfolio of properties, although this is a far less diverse way to invest as it's just one company.

Those who can afford it can also buy a property outright and lease it to companies themselves, although this is without question a labour- and capital-intensive - not to mention risky - way to gain access to the sector.

Within bricks and mortar funds, managers will typically invest in the whole spectrum of commercial property: offices, warehouses, shopping centres and car parks.

In addition, the properties are divided by quality into prime, secondary or tertiary property, and fund managers tend to specialise in a particular sector of the market.

Prime property, much as the name suggests, is good-quality property, usually situated in big towns and cities and attracting a string of top-drawer tenants.

Secondary and tertiary property is situated in less prime locations, with high-quality tenants harder to find. There's a higher yield available from these sub-prime properties, as the risk of void (empty) periods and defaults is higher.

WHAT TO BE AWARE OF

Property investors should be wary of three key areas: volatility, diversification and liquidity. On the upside, property funds can be less volatile than those focused on other assets, but direct property funds in particular are much less liquid because you are selling an actual property.

It can be especially hard to sell in a market crash. Note that open-ended funds are particularly sticky in such a situation because although the fund manager will keep a slug of cash to cover redemptions, if there is a sustained run on the sector they may have to sell properties in order to meet investor demands.

This can be a particular problem when the wider property market is on a downward trend, as the manager may well have to sell at a loss in order to maintain liquidity.

At times when there are more sellers than buyers, managers can switch from (higher) 'offer' to (lower) 'mid' or 'bid' pricing on their commercial property funds. This effectively reduces the value of funds by between 5 per cent and 6.25 per cent.

In a worst-case scenario the fund may be 'gated' or closed, so that no further redemptions (or purchases) can take place for a while.

Closed-ended funds such as investment trusts are more liquid, because investors can sell their shares in the trust, but this in itself does not put pressure on the manager to sell the underlying assets.

Investors in commercial property funds should ensure they take a well-diversified approach.

Gordon Kearney, investment director of Colchester-based Fiducia Wealth, says: 'Investors should be wary of funds that are too concentrated in one particular sector or region; a good spread of properties across retail, office and industrial should diversify sector-specific risks.

'They should also be cautious with funds only holding a small number of properties, which increases tenant-specific risks. Ideally you are looking for a fund to hold at least 40 properties.'

The main disadvantage of commercial property is that the location and management of the property is 'everything', according to Les Lang, head of the Infinity Real Estate Development fund. 'Get these wrong and commercial property can be unforgiving,' he adds.

It's also worth remembering that commercial property funds can be slightly more expensive than funds invested in other assets.

We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.