Property Investment Guide: Part One

By Jonathan Neale – property and business journalist

Commercial property has never been more popular as an investment. The collapse in share prices in the early part of the decade and the relatively poor performance of other asset classes has seen more money wash into bricks-and-mortar than ever before.

With good reason too – it has outperformed every other investment type by a significant amount. Returns are now approximately around 10% across all sectors.

Traditionally, commercial property is divided into three sectors: offices, retail and leisure, and industrial. I will be looking at each area separately in the Part Two of this guide, but the fundamentals you need to examine cut across all sectors.

Yield

As the majority of commercial property investments on offer tend to be let, one thing is vitally important: yield. This simple calculation of the annual rent divided by the price paid is at the heart of property investment.

If a building is let out at £10k per annum, and costs £141k, the yield is approximately 7% – a fairly typical figure for small commercial premises. It means that, in rent, you are likely to recoup your investment in just over 14 years.

After that, anything you receive is pure profit. The higher the yield, the faster you will break into that profit margin – the lower the yield, the longer it will take to hit that point. The difference between the two is down to security of tenure.

Rent

Unlike bank interest, rent is not guaranteed. Contracts can be for any length of time. Traditionally, they were for more than a decade, but recently leases have tended to shorten, with tenants opting to pay more rent for that extra flexibility.

Commercial leases can also have break clauses, usually at three or five- year periods, allowing the tenant to exit the lease without penalty. They are usually offered, again, to secure a higher rent or to secure a contract with a particularly secure tenant.

It is not just lease length that will determine the security of income from your investment. Covenant – the financial security of your client – is also involved.

If the business goes bankrupt, you will have to find another tenant before your income stream is restored. There is no guarantee that it will be at the same rent or on the same terms.

Landlords tend to demand more rent from businesses they view as risky or not fully established. This means that you will often get more returns, in the short-term, for the same amount of money – a higher yield. Like all investment though, that premium comes with a higher level of risk.

Rents can increase – check the terms of the contract, but typically rents are reviewed every five years, usually through an inspection by a chartered surveyor.

So while yields represent returns on investment, they also suggest risk. However, in a competitive market, it can be difficult to tell, as the demand for all types of property forces prices up and yields down.

Risk

Risk is lowest for buildings that are multi-let, i.e. have a number of tenants. This diversity of income means it is very unlikely to cease completely, whatever the economic climate.

Those leases may all have different end points, lengths and terms, meaning that management can be a complicated process.

Of course, people do not buy property just for income. As with residential property, they buy in the expectation that it will be worth more when they come to sell it. They want to see an increase in capital value.

However, this is where commercial property differs from the housing market. If you buy a house, in most cases, you will be living in it, or renting it to someone who will. People will always need houses, so there is an intrinsic value to bricks-and-mortar.

Commercial premises are different. Their value is almost entirely dependent on the income it will or could produce, and how secure that income will be. If there is no tenant, its value will be a lot lower than a tenanted property.

A building without a tenant, or hope of finding one, is relatively worthless as there is no potential for getting income from it.

This is often the case with very old industrial or office units, where the only value is in the planning consent. This enables them to be redeveloped, but even this may not be worthwhile if the economy in the town in question is not up to scratch and new business is few and far between.

However, investors can often make a profit on a building a few years after purchase if yields have dropped, prices have risen and there is still a significant amount of time on the lease.

Capital values

The real money to be made is in increasing capital values, through what is called active management. This might involve changing the terms of a lease so it is more favourable to other investors, or allowing lease assignment to another tenant who will rent for longer or for a higher rent.

The real achievement of any landlord is to secure another letting at the end of the original lease term. With the exception of shops and pubs, older buildings tend to result in lower rents and shorter leases.

Even a modest lease can result in a reasonable capital gain to add on to your income stream.

Empty buildings are ultimately the riskiest investment of all, and therefore offer the chance for the highest returns. If you can secure a tenant, then high income and capital gain is on the cards.

It is essential that you ask yourself why it is empty. If finding a tenant is an easy task, why has the owner not done it already and secured those gains for himself?

An understanding of the basics of rent, yield and capital gain is a must if you are thinking about buying an investment property, and, the outcome is almost always a positive one.

The UK economy is particularly robust and stable, and this is just one of the reasons why property here is seen as such as great investment right across the globe.