Win-win situation
The potential for UK commercial rental growth is set to increase as the economy gains in buoyancy.
The UK property market offers some unique opportunities, but results hinge entirely on opting for the right sectors at the right times. Ten years ago saw the birth of the “buy to let” phenomenon in the UK residential real estate market. Following a protracted recession and poor investment returns from other asset classes, rental income yields looked extremely attractive. They stood at about 8 per cent, which compared to low interest rates, which had fallen from 15 per cent to 6 per cent in less than two years. A decade later, house prices have doubled in some areas and it is now likely that we will see a period of consolidation. However, an uncannily similar opportunity now exists in the commercial property sector. The Investment Property Database (IPD) statistics reveal average rental income is 7 per cent. This represents nearly 3 per cent more than is available from equities or gilts, at a time when it is possible to borrow at fixed rates of around 5 per cent. Secure base Long leases in the UK (up to 25 years) with upward only rent review clauses, which mean that the rent can never fall, provide a secure base upon which to borrow. Borrowing about 60 per cent of cost can inflate the income return to over 10 per cent. This is hugely attractive compared to interest available from other sources. The capital value of a commercial property is determined by the rent and the investment yield. If the rent rises or the investment yield falls, the property owner will see capital growth. But if either a tenant defaults or the investment yield rises, the owner is likely to suffer a loss. The potential for rental growth will be determined by the vigour of the economy. Unlike during the 1980s, the past five years have seen far less speculative development in commercial property. This means that shortages of space should develop at a much earlier stage into an economic recovery this decade than in the last. By contrast, the high commercial property yields relative to the other asset classes make a fall in investment yields look likely, especially if inflation and interest rates remain at their current levels. Thus in a sluggish economy with low inflation, property may see capital growth from declining investment yields and the capacity to generate high income using low cost debt. In a more buoyant economy there may be less of a decline in investment yields but more potential for rental growth. It is hard at present to see a similar “heads you win, tails you win” scenario for any of the other asset classes. Open and closed Private investors seeking entry into the UK market have the choice of investing in open-ended funds (such as unit trusts or Oeics) or closed funds (usually limited partnerships). The attraction of open-ended funds is their liquidity, as investors can buy or sell at weekly or monthly intervals. A range of funds is available across the spectrum, investing in ground rents, residential property, shops, offices, budget hotels and industrial property. Funds of funds are also on the market, including the Close Property Fund of Funds called PIP, comprising sub-funds with a simple income of capital growth choice and with investments in dollar, euro or sterling. Three to five years Limited partnerships are specific investment projects with an investment term usually between three to five years, during which time there is little opportunity to sell out. Limited partnerships generally offer higher potential returns in exchange for higher risk. Typically, limited partnership participations start at Ł25,000 (e35,000). A partnership acquires individual properties or portfolios aiming at generating higher income or reducing investment yield (and thus increasing capital values) over three to five years. In the future it is likely that wealth managers will place increasing emphasis on spreading portfolio allocation across asset classes. Property clearly needs inclusion, whether at 20 per cent or more. Given that commercial property has returned over 10 per cent per annum over most periods since 1970, according to IPD, it is a shame property has been ignored for so long by so many. Anthony Wyld is managing director of Close Property Investment.
