Introduction to commercial property investment

What kind of property are we talking about?
What Return can I expect in the current market?
Why not just choose properties showing the highest initial yield?
How much are the transaction costs? I have heard that transaction costs on property are very high: For instance stamp duty.
Are there any reasons for buying the low risk properties apart from the "Net Initial Yield"?
What are the drawbacks I have to put up with to get this higher secure return?
What is the place of property in my investment portfolio?
What about VAT on Property Purchases?
What about Property Management Costs?
What about borrowing against the property?
What is the most tax efficient way of investing?
Why not invest in residential property? I've heard a lot about "buy to let".
I am prepared to accept the lowest yield in the commercial property spectrum, because I want the most secure investments, those let to the largest most undoubted companies with long unexpired lease terms. However, surely properties let to large businesses are multi-million pound investments? I won't be able to find one for a few hundred thousand or even a million pounds.

What kind of property are we talking about?

Office, Industrial and Retail properties let to businesses and producing rental income. [BACK TO TOP]

What Return can I expect in the current market?

From 5% or 6% p.a. initial income yield for "management free" lowrisk properties let to large businesses with a long unexpired lease term.

From 7% p.a. initial yield for properties let to medium or large businesses with, say, a 5 to 8 year unexpired lease term.

Higher returns, sometimes much higher, for "management intensive" or "risk/reward" properties let to a variety of tenants on short term leases, perhaps part vacant or with redevelopment potential to provide an opportunity of adding value. [BACK TO TOP]

Why not just choose properties showing the highest initial yield?

You probably know the answer! - but, for the record:

1. The terms "intensive management" and "risk/reward" properties - mean exactly what they say. We would only recommend these higher yielding properties to investors who have hands-on property management experience themselves, or who wish to invest alongside one of our professional property investor clients who can, with our help, handle the day-to-day management and periodic lease negotiations required.

2. The "management free" properties let to undoubted tenants on Full Repairing and Insuring ("FRI") leases (the tenants pay for all the maintenance and repair) do, of course, offer a lower initial yield but one that is still probably a good deal higher than other low-risk investments. For example, a freehold high street property let as a bank branch shows its owners, at 5 to 7% yield, a substantially higher income than they would receive by putting their cash in a deposit account with the very same bank. [BACK TO TOP]

How much are the transaction costs? I have heard that transaction costs on property are very high: For instance stamp duty.

As is the case with calculating return from shares, bonds and unit trusts, your financial and tax advisers' and/or fund manager's fees are not taken into account in calculating the yield. However, the property transaction costs are . The income returns on direct investment in commercial property are usually expressed net, i.e. after taking into account your transaction costs.

For example, if a property investment is let at a rent of £31,728 pa, and you pay a total of £528,812 including purchase costs to buy it, the investment is said to show a Net Initial Yield of 6% per annum, because the costs are added to the purchase price (in this instance the purchase price is £500,000) before calculating the net income return.

The £28,812 costs consist of the following (calculated on the purchase price):

To put it another way, the gross initial yield in the above example is £31,728 divided by £500,000, i.e. 6.35%. 6.35% divided by 1.0576 is 6.00%, which is the Net Yield on which the property's value is calculated.

Please note, however, that our fee for transactions below £500,000 is 2%. [BACK TO TOP]

Are there any reasons for buying the low risk properties apart from the "Net Initial Yield"?

The main reason in today's low-inflation environment is to obtain a secure income at the stated yield.

However, as the term "initial" implies, there is potential for growth. Rents can increase at inflation rate or more - but increases cannot be assumed , for various reasons which we will discuss with you if you decide to talk to us about making an investment. However, the rent cannot go down under the leases of the low risk properties discussed above.

The 2% or less average net dividend yield on shares (so low-risk property provides a rental income of two and a half to three and a half times that of dividend income from shares) and the comparative volatility of the capital value of shares makes the rental income alone a good reason for holding commercial property.

The potential capital gains from shares bought and sold at the right time are probably greater but so are the risks. Apart from bankruptcy or lease expiry, property income level is secure. When a company is facing difficulties it can cut its dividend but it must pay its rent to stay in business. [BACK TO TOP]

What are the drawbacks I have to put up with to get this higher secure return?

Property compared with shares is as cold porridge to water: It may be more nutritious and substantial but it comes in lumps and it is less liquid.

In other words
(a) you can buy AAA shares for a few thousand pounds but a secure property will cost at least a few hundred thousand pounds
(b) you can buy and sell shares quickly (at least, those of large quoted companies) but it takes time to sell a property.

The higher transaction costs, though they don't affect your initial return, are a capital disadvantage if you want to sell quickly. Property should be held as a medium to long term asset.

Of course, one might be inclined to say that an income yield which is triple that of stock market shares is abundant compensation for these drawbacks. [BACK TO TOP]

What is the place of property in my investment portfolio?

Some investors are very attached to property and invest all or nearly all their investment funds in it. Typically, however, property's place in your portfolio is probably alongside your shares and bonds as another basket for your eggs, i.e. as part of a balanced portfolio spread that combines investment products which have differing levels of volatility and different economic cycles. [BACK TO TOP]

What about VAT on Property Purchases?

There are quite a few investment properties which are not registered for VAT. So you would not pay VAT on the purchase price or have to charge it on sale. However, it is useful to register for VAT or use a VAT registered company in which to buy your properties, because many commercial investment properties are VAT registered and your ability to reclaim VAT on purchases (immediately if arranged correctly) would eliminate the dilution of your return on VAT registered properties. [BACK TO TOP]

What about Property Management Costs?

Properties let to more than one tenant need managing - but almost all "FRI" (see above) leases will provide for you to charge the tenants a management fee (we and your solicitors will study the leases and make sure they do on any property you buy!). This enables you to employ a managing agent, for whom the tenants pay under the service charge provisions in their leases. You may also be able to charge for your time in dealing with your managing agent. [BACK TO TOP]

What about borrowing against the property?

One advantage of obtaining a loan against your property, usually about 60% to 75% of valuation, is that it enables you to buy larger properties as well and therefore gives you a greater choice. Another is that it increases your potential capital gain on the equity you invest. You would also benefit from an increased rental income return on your equity if the yield on the property is greater than the interest rate on your loan,. This needs to be examined on a case by case basis because, although the long term benefits of borrowing are usually clear, the capital repayments can affect your cash flow. This is a reason why some commercial property investments these days are made on an "all cash" basis without recourse to borrowing. [BACK TO TOP]

You should consult your Independent Financial Adviser and your Tax Adviser before deciding on a property investment or the best way to fund the purchase.

What is the most tax efficient way of investing?

Your IFA and your tax adviser will also be able to advise you whether your property investment might better be held in a Self- Invested Personal Pension (SIPP). For instance, the income from commercial property held in a SIPP has in the past received better tax treatment than the dividend income from shares held in one - but new legislation on this subject and on other aspects of private pensions (e.g. limits on the maximum tax advantaged fund allowed) appear to be under consideration.

Update: From April 2006, trustees will only be able to authorise borrowings up to a limit of 50 per cent of the total assets in the pension fund. (Currently, Sipps can borrow up to 75% of the value of each commercial investment property purchased).
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Why not invest in residential property. I've heard a lot about "buy to let".

We don't generally deal with residential investments. We will say, however, that at today's prices the net income returns are much lower than those for commercial property, the income is less secure because the tenancies are usually 6 months to one year long and the tenants of relatively unknown standing and, finally, they do require firm and time consuming management. [BACK TO TOP]

I am prepared to accept the lowest yield in the commercial property spectrum, because I want the most secure investments, those let to the largest most undoubted companies with long unexpired lease terms. However, surely properties let to large businesses are multi-million pound investments? I won't be able to find one for a few hundred thousand or even a million pounds.

There are a fair number of small commercial properties let to good tenants and valued at between, say, £300,000 and £1m. Shops and bank branches in market towns will often be comparatively small. Occasionally, small office buildings or industrial units are let to departments of major companies or even of government.

Alternatively, if you wanted to participate in much larger properties, or to buy only a part of a smaller one, your Independent Financial Adviser may be able to organise a syndicate, allowing you to buy a property investment alongside other investors in the same property. [BACK TO TOP]