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Falling yields in the residential lettings market have attracted growing numbers of private investors to commercial property, lured by generous tax breaks and higher rents.

How does commercial property differ from residential property?

The commercial property sector is much smaller than its residential counterpart but the average cost per property is much greater. According to Nationwide, the average residential property price in the final quarter of 2004 was £152,623 whereas the average value of commercial properties at the end of 2004 as measured by Investment Property Databank, which analyses property data, was approximately £10.99m. Yields on commercial property vary according to the location and quality of the property but also according to the tenant. A strong bank will tend to pay a lower rent (meaning a lower rental yield) than a struggling retailer. But overall yields will also be affected by occupancy rates. So if there is a downturn in the economy, yields on, say, office blocks or shopping centres could suffer.

What comes under the commercial property umbrella?

Commercial property can be divided into three main categories with retail property (shopping centres, retail warehouses, high street shops and department stores) the largest.

Office property is the second largest sector and industrial property the smallest category by value, covering industrial estates and distribution warehouses.

How can investors get into the commercial property market?

The private investor has a variety of indirect investment routes into commercial property. The easiest way is to buy shares in property companies such as Liberty, Land Securities and British Land. But the performance of shares in these companies tends to follow that of the stock market rather than the commercial property sector so returns can be more volatile.

Another way in is through a life insurance company property fund, offered by most major life insurance companies. But it’s worth remembering that within a life policy fund there is typically an internal capital gains tax charge. Gains on single premium life policies are also subject to an income tax charge for higher rate taxpayers.

Authorised unit trusts are an attractive way in but there are still very few of these that invest directly in commercial property. It is not possible to hold a property unit trust in an individual savings account (Isa).

Private investor network Hotbed also gives investors the ability to buy a large stake in individual commercial properties. This is a more risky way of investing than in a fund but could produce higher returns.

There are also other investment vehicles such as limited liability partnerships which can have high minimum investment levels and offshore funds in a range of forms.

What sort of returns can investors hope to get?

Figures from Investment Property Databank and New Star investment managers show that property yields have been locked in a 5 to 8 per cent range for the last 10 years.

The average income yield from commercial property at the moment is around 6.77 per cent, according to IPD. In comparison, before inflation adjustment, UK shares currently yield a little more than 3 per cent and gilts around 4.3 per cent.

Are there any tax advantages to investing in commercial property?

The UK tax regime has two important features that makes property an attractive investment. First, interest on loans to finance the purchase of property can be offset against rental income. Second, rental income is normally received by investors without deduction of tax. This is particularly important for tax-exempt vehicles such as pensions.

What are the prospects for commercial property?

The government has been discussing the idea of creating a new investment vehicle for both commercial and residential property called Real Estate Investment Trusts. In the US, Reits have transformed the property market, with most US property companies converting to the Reit structure and experiencing heavy interest from income-hungry private investors.

What are the risks?

Like equities property prices can go down as well as up. Investment in a single commercial property can run into millions so getting a decent spread of different properties via direct investment is very tough. A fund will tend to have exposure to different types of commercial property, broadening the risks.

By its very nature, commercial property is an illiquid asset and values can be hit if you need to sell quickly. It is a very specialist sector and could be volatile in adverse market conditions. There is also the risk of the loss of income from a property if the tenant chooses not to renew the lease on expiry.

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