Buying a house not only puts a roof over a person’s head, it provides financial security over the long term and can be a great way to invest your money.
However, it is not entirely safe. For example, when the financial crisis hit in 2007 many property investors got their fingers burnt, demonstrating that investing in property is not without risks.
With that being said, commercial property is an important asset class to consider, as it is an efficient way of spreading, or even diversifying the risk within your investment portfolio.
Usually, property is not highly correlated to other asset classes including cash, fixed income (bonds and gilts) and equities, meaning that property values move more independently to other assets and are not typically affected by the stock markets.
So, what are the various ways of investing in commercial property?
There are numerous ways of getting exposure to properties as an investor:
Direct investment
For private investors, a direct investment in a property means you are buying all of, or a share in, a property. For many, this is not the most practical way of getting exposure to the commercial property market.
Direct commercial property funds
Also known as ‘bricks and mortar funds’, this is a more common method of investing in commercial property, which can be done by a collective investment scheme, such as a unit trust, OIEC or investment trust.
These invest directly into a portfolio of commercial properties including supermarkets, offices, and warehouses, which are normally inaccessible to smaller investors.
Indirect property funds
These are collective investment schemes that invest in the shares of property companies that are listed on the stock market.
They do not have the same benefits of diversification as direct investment properties, as shares can move up and down with the stock market trends.
There are two key ways that you can earn money from a commercial property investment:
- Income from renting to a tenant.
- Capital growth from an increase in the value of the property.
Investing in commercial property funds
Many investors prefer the more familiar route of investing directly into residential property however, commercial property can offer a simpler and lower-cost alternative.
Commercial properties can cost millions of pounds to purchase or build, and can command huge rental incomes but, in most cases, they are impossible for smaller investors to buy outright.
Therefore, most investments in commercial property come through investment funds, such as unit trusts, OIECs or investment trusts.
These funds either directly own commercial properties and pay your returns based on their growth in value or rental income, or purchase shares in property related companies, paying you returns based on the growth in the value of the shares and the payment of dividends.
Typically, you only need around £500 to invest a lump sum in a property fund, or £50 per month for regular savings.
There are three categories of commercial property:
- Retail property – which includes shopping centres, supermarkets, retail warehouses and high street shops.
- Office property – these are usually purpose built for businesses, these often require installation of high-speed internet and other services that are essential to the business.
- Industrial property – this includes industrial estates and warehouses.
Why could commercial property be a good investment for you?
The UK benefits greatly from a longer lease structure in comparison to Europe and the US. The average lease length across the UK is approximately 8 years.
This is much longer than what you would get from a residential property, which generally has leases of 6 months to a year.
This structure potentially offers more security relative to the returns offered by shares, as income is guaranteed at a set level for an extended period.
What are direct or ‘bricks and mortar’ commercial property funds?
Bricks and mortar funds refer to direct commercial property investments, meaning that physical properties are bought by the fund. The risk is spread across several different properties, meaning that if one property is not occupied (and therefore earning no income from rent), others within the fund can generate income.
Your returns come from a combination of increased value of the properties in the fund and, more importantly, the rental income.
Rental income provides you with an annual return and when you cash in your investment, you will hopefully receive the sum you initially invested, plus any growth in value of the properties within the fund.
Benefits and risks of direct commercial property investment
With direct property funds, rental income can be relatively secure in comparison to other asset classes. This is because of factors such as long lease lengths (typically five years or more), less risk of non-payments than residential properties and upward rent reviews, meaning that rental income increases by at least inflation each year.
You also do not have the hassle of property management, which falls to the manager of your fund. It is the property manager’s responsibility to source tenants, invest in property in prime locations and negotiate lease lengths.
However, a major downside of direct investments is that the property markets are highly illiquid compared to most other financial markets. This means that buying or selling the property could take months, making it difficult to sell your holding in the fund quickly.
Beware the lock-out of direct commercial property investment funds
When the financial crisis rocked the UK economy, many direct property investors found that they could not take their money out as property values plunged.
This is because property funds have a clause that allows fund managers to shut off payments to investors wanting to exit the funds if there are ‘exceptional circumstances.’
Under Financial Conduct Authority rules, property funds can suspend trading for 28 days while they try to raise enough cash by selling off properties to meet the repayments of the investors looking to reclaim their cash.
This 28-day period can recur until the fund has enough capital to meet redemptions, and during the financial crisis of 2007-08, some of the suspensions lasted as long as 12 months.
Fund managers argued that this was for the benefit of the investors, as a fire sale of properties in such conditions would mean that they would not be able to realise their full value.
What are indirect commercial property funds?
Indirect funds, usually in the form of unit trusts and OIECs, buy shares in companies that invest in property. These shares are listed on the stock exchange and traded daily; therefore, they do not have the liquidity problems of direct commercial property funds, meaning you can move in and out of the fund freely.
Returns from this fund are gained like any other investment in shares, through share-price appreciation and dividend income, rather than directly through property price increases and rental income. However, while you get the benefit of the liquidity of an equity-like product, you also get the unpredictability of investing on the stock market.
Real estate investment trusts
The vast majority (over 80%) of these property companies are known as Real Estate Investment Trusts (REITs) and have greater tax benefits than other listed property companies.
REIT companies do not pay corporation tax on their assets on the condition that 90% of their profits are paid to their shareholders as dividends, which in turn, could mean higher pay-outs. REIT investors pay either 20% or 40% tax, because they are classed as property letting income.
Property investment trusts
On the other hand, you could invest in property investment trusts, which will pool your money to buy property and property company shares.
The difference between these and REITs is that they are considered to be like any other company, so tax on dividends for the 2022-23 tax year is 8.75% for basic-rate taxpayers on any dividends over £2,000 (up 1.25% from 2021-22). This increases to 33.75% and 39.35% for higher and additional rate taxpayers respectively.
Investment trusts can do things that unit trusts and OIECs cannot. For example, many property investment trusts use gearing – this is a process whereby companies borrow money – to boost the amount they can put into the property beyond what has already been invested.
While this can enhance gains in a rising market, it can heighten losses if returns fall.
