The only way is up

The danger point (as is for any investment) is that property investors become exuberant and take risks to capture the demand for property and profit from this.

Direct commercial property appears an attractive asset class for investors; returns coming from both rising capital values and yield (rent).

With rising interest rates we considered the potential impact this would have on the residential market. In this blog we consider if residential and commercial property are interlinked and whether a rise in interest rates is bad news for commercial property investors.

Key differences

Investing directly in commercial property is expensive and this is a barrier to private investors entering the market. Initial and ongoing costs can have a significant impact on returns. In fact private investors make up only 2% of the commercial property market with the main investors coming from overseas at 24%.

There are other differences. The majority of businesses rent their premises; this is currently at 56% whereas the residential market is 37%. For investors it is an attractive market with leases set for longer periods (currently averaging 4.5 years) and rental income across all property classes averaging 4.70%. (Source: Property Data Report 2014).

And importantly commercial property is less indebted than residential property. This is important because as rates rise the cost of servicing debt is not a significant expense and therefore the impact is not as bad. (But this can change!)

Tenants vs Landlords

You could argue that where landlords dominate the market, tenants are in a weaker position (that certainly seems to be the case with residential property).

But with commercial property this is changing.

  1. In 2003 63% of leases were for fewer than 5 years, this has now increased to 80%
  2. Average rent terms have reduced from 6.8 years to 4.3 years
  3. Leases are more flexible with break clauses and rent free periods
  4. We have also started to see rental costs coming down slightly

“This is a market that has fairer rental controls with the costs of renting averaging about 7% of staffing costs.” (Source: Property Data Report 2014).

Direct commercial property investment

Commercial property is subject to different stimuli than residential property. A rising interest rate environment or an acceleration in inflation can be positive for commercial property as it is a sign that the economy is strong. At these times investors are confident and demand for commercial property is at a high.

The danger point (as is for any investment) is that property investors become exuberant and take risks to capture the demand for property and profit from this.

If we take three property cycles, there are historical similarities in 1973, 1990 and 2007. In all cases as the demand grew investors took on more risk (more debt) forcing up property values. But as the economic outlook declined, companies went bust, demand for space dropped and those investors with high levels of debt couldn’t service it making them forced sellers. This resulted in a sharp fall in asset values.

As an example, in the most recent crash the 2007 property values peaked at 60% above the levels seen in 2000 but declined nearly 50% by 2012. (Source Bank’s Financial Stability Directorate).

What we have seen since 2007 is investors significantly reducing debt.

Interest rates

We have highlighted that rising rates are a sign that the economy is improving. The Bank of England is looking for the point at which the economy is strong enough to absorb that rise.

If we reflect on the fact that demand is strong as companies are buoyant about the economy and that investors have less debt, then any rise in interest rates shouldn’t have a materially negative impact for commercial property investors. It should also be added that properties are not overvalued and rent is stable. A recent update by Schroders indicated that they saw growth from the sector over the next five years (although of course this is not guaranteed).

The time to be concerned is when investors take on more debt to respond to the demand. All three cycles show that this is the root cause of a subsequent slump in property values. When a downturn kicks in businesses stall, demand falls and there is a downward pressure on rent. Those investors with too much debt are the first to suffer in this environment.

Conclusion

Direct commercial property investment only appeals to a minority of investors in part due to the barriers to entry (costs and high valuations) but also the complexities of the market. There is little evidence at the moment that the market is overheating and any increase in interest rates should have a minimal impact.

However, the point to watch is where the level of debt starts increasing and the economic cycle starts to peak. At this point history shows there is likely to be a correction which will be hard for those with debt to absorb.

Source: Property Data Report 2014, Schroders ‘The attraction of real estate in a rising interest rate market’ and Schroders ‘The attraction of property in a rising interest rate market’.

Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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