TODAY it is difficult to build a diversified portfolio as many assets considered defensive, such as UK gilts and cash, are either expensive or offer little return. One asset class that can fill this void is commercial property.
While the performance of property investments is ultimately linked to economic performance, property does not respond as rapidly as equities and therefore provides some valuable diversification benefits within a portfolio.
It is also one of the few investments still providing a reasonable income of circa three per cent after management charges. This feature of commercial property means that its value tends to be largely based on the reliability of regular rental income rather than emotional decisions that can sometimes affect stock markets. Accordingly, the performance of commercial property is normally less volatile than some other types of investment, most notably shares.
This provides some much needed gilt-like ballast to portfolios when gilts and other defensive assets look like poor value.
Commercial property has two big advantages over residential property, which many may be more familiar with. The leases typically last longer and there is usually more chance of the rent being paid as businesses are generally more reliable tenants with access to larger sums of money.
Leases on commercial property can be for five or ten years – or longer – meaning a commercial property investment offers the scope for predictable, regular income that lasts the life of the lease.
What is more, rental rates are normally reviewed every five years and in many cases can only be revised upwards.
Commercial property also has the potential for capital growth. Property managers work hard to enhance this by improving the properties and trying to attract better tenants. There are also peaks and troughs in supply that investors can take advantage of. For example, property tends to perform well in the latter stages of an economic cycle when demand is picking up but the supply is still being built.
There are four key factors that investors should consider before making an investment in property.
The first is supply and demand. When the economy is doing well, businesses prosper and look to expand, seeking more space and vice versa.
Therefore, investors should look to acquire in areas of economic growth and consider the supply of credit to developers. Currently lenders are not supplying much credit to the sector and that is keeping supply tight and values high.
The second is the financial strength of the tenants. If a tenant is financially strong, they are less likely to default and stop paying the rent. A longer lease also means greater security for the owner.
The third is the location and quality of the property. The highest-quality buildings in the best locations attract the highest rents. However, a property’s status can change both positively and negatively.
For example, a prime retail shop might be downgraded if it is not maintained or if a new shopping centre nearby takes away some of its customers. Many investors are currently wary of London property as it is most likely to be adversely affected by Brexit.
Finally, the difficulty in buying and selling property must be taken into account. Unlike many other types of investment, property is quite difficult to buy or sell, the process takes time and you need a lot of money to invest directly. To use the technical term, property is illiquid.
If a property needs to be sold quickly its value can suffer. We saw this first hand following the Brexit vote, when fears about the impact on commercial property sent some investors scurrying for the exit.
This caused a sharp decline in the value of property shares and investment trusts and most of the large property unit trusts suspended dealing for several months.
Investors should therefore also consider co-investor risk, which is the risk that a sudden shock might result in your fellow investors panicking and your investment being frozen for a period.
David Thomson is chief investment officer at VWM Wealth.