Copyright David Lawson - Property Week 2004
Interest in property has boomed in the last few years as sacred cows including equities, endowments and managed pensions went spectacularly mad and collapsed foaming at the mouth. Thousands found an alternative investment in buy-to-let housing. Commercial property then caught the blast of revolution and auction sales overflowed with new buyers loading up their personal pension funds with high street shops.
Lenders quickly caught on. The startling figures blasted out quarterly about soaring mortgage debt obscure huge flows pouring into commercial property. And despite the recent stock market recovery and rent freeze, this boom is set to continue.
The government is considering allowing homes to be held in small funds, opening up a vast amount of space above high street commercial property around the country. An even bigger revolution is brewing if real estate investment trusts get off the ground, finally opening the sector to a vast number of small investors looking for bolt-holes that are both tax-friendly and easy to handle.
But how many of these new investors understand what they are getting into? Very few if the evidence of current and past trends are any guide. People find it hard enough to appreciate the risks of buying their own homes when the herd instinct takes over. Look at the way house prices have soared far beyond the levels which sparked massive repossessions a decade ago.
The new generation of residential landlords shows dangerous signs of similar blinkers. Yields are now less than an internet current account in many areas, yet buy-to-let continues to flourish.
The major barrier to pension flexibility and the kind of REITs seen all over the world except the UK is a nagging doubt among ministers and Treasury minders that investors could pile in with similar abandon. As one analyst closely involved in negotiations to introduce a more favourable tax regime says: ‘They are petrified about what would happen if there was a crash and thousands of voters were ruined because they had ploughed into property.’
It happened in the US 20 years ago, when money was heaped into savings and loan groups which collapsed with such force that Washington had to step in to prevent the whole finance sector disintegrating.
Doubters also point to the fact that property is a wonderful investment as long as taken in small doses. Development has a habit of matching the amount of money available rather than occupiers’ requirements. One legendary figure was asked in the last-but-one crash why he kept building when there was no demand. ‘Because I’m a developer,’ he said.
It wasn’t his money, so why worry? Lenders are also notorious for being slow to turn off the tap. Robert Finch, senior property partner at Linklater, raised similar doubts last month, warning that tight regulations were needed to avoid the threat of oversupply driven by a flood of new capital. Dodgy investment schemes could also flourish in the same way as buy-to-let brought out a pack of sharp operators.
Some would say there are checks and balances in place to stop this happening. Tough restrictions prevent non-professionals investing in most kinds of commercial property – other than buying their own - unless they go through independent financial advisors. So tough, in fact, that authorised property unit trusts have never more than scratched the surface of potential retail funds.
That kind of control seems likely to continue as politicians become increasingly nervous of financial scandals. IFAs are closely monitored by regulators’ and the rules are being tightened even further to prevent bad advice.
Yet how much do IFAs know about property? How much are bank managers aware of the nuances, let alone the basics of bricks and mortar? Very little according to managers who have struggled for years to launch new vehicles. They sweat blood constructing clever ways to exploit overlooked sectors such as industrial property or secondary offices for retail investors. Then one headline about collapsing rents in the City blow everything apart. It is a waste of time trying to explain that other kinds of commercial property can be completely unrelated to glossy office blocks.
There are honourable exceptions, of course. Some IFAs and mortgage managers are as sharp as any investment surveyor. But frustrated by this common problem and fearful of the backlash if the investment revolution goes badly wrong, the three top property bodies have decided to spread a little wisdom before it is too late.
Stephen Palmer, formerly with Chesterton, Knight Frank and Guardian Properties before setting up Seven Dials Consulting with top-flight number-cruncher Brett Robinson, knows all there is to know about the higher reaches of real estate investment. It came in very useful in the report he co-authored which persuaded the government to change its stance over REITs after a frustrating and fruitless decade of lobbying.
Then the RICS, Investment Property Forum and BPF extended the brief to an even more difficult task: explaining property to financial advisers. The result is a concise and masterful précis of the structure, rules and aims of the sector which would be a useful refresher even to gnarled professionals. It is certainly meat and drink to this gnarled amateur and will be pillaged unmercifully over the next few weeks to provide a précis of the précis.
Understanding Commercial Property Investment: A Guide for Financial Advisers www.7dials.com
Simple as bricks and mortar must rank among the most misleading of maxims. A new generation of landlords ambitious to graduate from the odd couple of buy-to-let homes into commercial property is quickly learning that there is more to this business than meets the eye.
Yet financial advisers often have a tenuous grasp - or have forgotten - the basics, so how can they advise on the complexities? Hardened professionals may sneer but many are acutely aware they could be embarrassed by the simplest of queries. A guide for IFAs has been a surprise hit with established property firms. ‘They are ringing up and asking for dozens of copies,’ says Stephen Palmer of Seven Dials Consulting, which was commissioned by the IPF, RICS and BPF to produce a path through this minefield. So what are the basics?
Investors: Commercial property in the UK was worth more than £445bn at the start of last year compared with £2,800bn of housing and £1,150bn of equities. Just over half of the commercial stock is owned by investors – and rising as owner-occupiers raise capital by selling and then leasing back premises. Institutions such as insurance companies and pension funds dominate the investment market, holding almost 45% by value. Next come quoted property companies [23%] and their equivalent private companies [12%]. Overseas investors owned 14%, half of that in offices, boosted by an influx of German funds and private Irish investors seeking better returns than they can find at home. Venerable landed estates like Grosvenor and the Crown Commissioners, often held up in the media as owning huge chunks of the UK, creep in at 4%. New-fangled limited partnerships propped up the list at a mere 3% but this does not account for explosive growth last year.
Sectors: Commercial property divides roughly into three or four sectors. Retail [ranging from corner shops to massive greenfield malls and discount warehouses], offices [from glossy City blocks and business parks to warrens above high street shops] and industrial [ which also includes warehouses. Some analysts now separate out leisure, but the boundaries blur over property such as pubs and restaurants, which are often integrated with shopping.
Location: The south-east dominates investment with 60% by value of offices – much of it in the City and West End – and more than 25% of industrial. This is because the dominant institutional investors and landed estates focus on this top slice of the market. The bulk of private investors are spread far more widely.
Investment Classes: Property is divided broadly into two investment types. Prime is the top slice, beloved of institutions, claiming the best locations and rents. Each town or city will have its prime office centre and a prime ‘pitch’ for retailers, while towns themselves will arrange into a regional or national league table of values set by rent levels. Secondary property is the stamping ground of property companies and private investors. It could be shopping away from the high street, a multi-let industrial estate or offices needing ‘massaging’ by a skilled manager to raise income by re-jigging leases or refurbishment.
Landlords and tenants: Freeholders own buildings outright. Tenants hold leases on which they pay rent. The boundary can blur where a lease runs for hundreds of years such as in central London, where landed estates like the Church Commissioners are ground landlords. Many councils around the UK are in a similar position. While these long leases are effectively a ‘virtual’ freehold, investors [and tenants] need to realise there is an extra layer which may impose restrictions on matters such as sub-letting and redevelopment.
Players and Payments: Developers are the sector’s manufacturers, assembling sites and building from scratch or the increasingly common renovation of older buildings. Speculative development is where funds have been raised and work begun before a tenant is signed. This is common for industrial, retailing and smaller offices but increasingly rare for major blocks because so much space is available while the economy recovers. Investors step in once space is let and the property has an income stream, although sometimes developers hold for their own investment portfolio or work in joint ventures with investment groups which pre-fund and take over the completed space.
Tenants are the cash-cows, committing to pay rents for leases ranging as long as 25 years. They are is the critical factor which makes commercial property a special investment, as no other sector except government bonds provides this kind of guaranteed long-term income stream. But this is also where complexity begins to bite. New government rules, shorter leases terms and qualifying conditions such as break clauses all muddy the water, so we will look more closely at leases later on as part of the underlying reasons for investing in commercial property
The final group of players glue the whole process together . Surveyors are far more than caricature theodolite-humpers. In various guises they do everything from buying and selling buildings to negotiating leases, managing property and crunching valuation equations that spill beyond the backs of a mountain of envelopes. Many smaller investors will have never met one, trusting only in an IFA. But as property moves more into the mainstream, it could be critical to understand how they work.
One of the great boons of the internet is that there is no longer any shortage of information about where to put your money. It is also the biggest drawback. ‘Investing in property’ produces more than 8,000 sources via the Google search engine, and that does not cover hundreds of mailing lists and user groups jammed with earnest advice and fervent debate.
But how do you filter through the dross? For every seasoned professional and skilful amateur there are dozens of shysters and idiots. Many are extrapolating the new enthusiasm for individual buy-to-let into all kinds of property without understanding the differences. Commercial real estate is a different animal to housing. Firstly, it tends to be more expensive. Beginners need to think of finding at least £250,000 and anticipate quickly moving past the £1m mark if they want to treat this seriously. ‘Anything less and you may as well stick to property shares,’ says Jeffery Selwyn of financial adviser Selwyn Knight.
Tenants are also very different. Firstly, they stay longer, taking leases ranging from a few years to a lifetime. The paperwork is more complex: 40-page leases are commonplace, despite efforts to this back to a few pages. That means few investors should venture into this minefield without a property professional. Even financial advisers are often bemused by the way leases work.
On the surface, they appear an iron-clad promise of long-term income unencumbered by nasty problems like management. Rents are reviewed every five years – sometimes more often - and tenants are responsible for repairs and insurance. They even have to return the property in the same condition by paying for dilapidations.
But there can be ticking bombs which surveyors and lawyers are trained to disarm. Break clauses, for instance, may allow a tenant to leave early. Leases signed prior to 1996 also conform to an historic concept called privity of contract, which basically means the original investor remains responsible for rent to the landlord, even though the property may have been sub-let many times over decades.
Since the government removed that restriction, tenants can sub-let to a rag-and-bone merchant with impunity unless controls are written into the lease. Strength of covenant [the credit rating of a company] is critical, so investment value can be damaged even if the rent keeps flowing. Ministers are about to add further risks. In response to grumbling by occupiers, landlords will be prevented from demanding ‘upward only’ rent reviews. That will remove a major attraction because, unlike residential investment, commercial property is driven by income rather than expected capital appreciation.
Other drawbacks can make property a prickly investment. Turnover is far lower than rival investments like equities because buildings come in bigger lumps. Transactions are also expensive, with fees averaging around 1.8% and stamp duty at 4% on lots above £500,000 – and rising. Low turnover means values are often estimated. The RICS imposes strict rules but the end result can still be a source of friction when so many variables are involved such as location, condition, market sentiment, lease length and tenant status. One reason auctions are common is that they provide a transparent, open-market price.
Performance is another problem that nags away at financial advisers looking to compare with rival asset classes. Equities and bonds are awash with indexes and ratios, analyses and tipsheets. They are cut and sliced into sectors, timescales and risk categories. Property got by on estimates and instinct until 1985, when the Investment Property Databank was established as a benchmark. It took a while to bed in but now follows more than £100bn of property across the UK. Investors can drill down to find monthly, quarterly and annual returns for various sectors like retail and industrial.
But even this has weaknesses. Figures mainly come from institutions and large companies, and may not reflect the property of interest to private buyers. Nor do they show market transactions but are drawn from valuations, with all the uncertainties they contain. So why bother? Many investors don’t, which is why property has been the poor relation for so long. But the sector is being re-assessed as more advisers realise the attractions. Property produces a long-term secure cashflow. Leases may be getting shorter but still average more than 12 years. Returns are stable, averaging 7.5% over the last decade and outperforming gilts and cash over three, five and 10 years. Equities ate the better bet only over 30 years.
But this is not an either-or choice. Holding some property is a way of diversifying risk as returns show a low correlation to other assets. In other words, when shares and interest rates are down, property can be up. Perhaps the biggest influence on a new generation of property investors is the proliferation of various trusts, partnerships, offshore companies and other pooled funds. These overcome problems of valuation, management and liquidity and have entry costs only a fraction of the most basic property. A further boost to indirect investment is expected as the government considers allowing reducing the tax burden on a new generation of trusts and enabling residential into personal pension funds. They come at a price, however. Two layers of fees may be charged for managing the fund and the property.
Borrowing is not for the faint-hearted. Property seems a no-lose investment when interest rates are well below average returns and there is certainly no shortage of lenders scrambling to cash into the boom. But the line between success and failure can be remarkably thin.
Bricks and mortar are rarely as straightforward as they appear. A shop tenant could go bust overnight. Building inspectors may appear half way through a house conversion and demand expensive changes. Will the lender ride to the rescue or send in the heavy mob?
The secret to success lies not just in the rate of interest but who is doing the lending and how much small print they cram into the agreement - which is why a huge industry has emerged to advise investors. Beginners may find the first steps remarkably easy. As a rule of thumb, first-timers borrowing up to £250,000 should start with banks and then consider moving to specialists as they become more knowledgeable
‘Start with who you know – your bank manager,’ says Jeffrey Selwyn of advisers Selwyn Knight. The major banks and building societies contribute something like 80% of finance to schemes ranging from a high street shop investment to development of a housing estate.
But reputations vary. Nationwide is highly efficient while Royal Bank of Scotland is renown for its 300 specialist property advisers. Others are not so well considered because loans can take weeks or even months to get through a web of bureaucracy. And people move on in large organisations, breaking vital personal relationships.
Agreements will be different to house mortgages. Commercial property loans are shorter, ranging as low as a few years, because they are based on lease length – the amount of time income is assured – and are generally between 60% and 85% of the property value. The guiding principle is the same as buy-to-let: investors should limit capital repayments as only interest can be set off against tax. Aim for a surplus to repay capital. Current rent is no guarantee of success. What if a tenant leaves? Is the area and property good enough to snare another one quickly?
Small print can be critical. Watch for early repayment penalties: trading up or cashing in after in a few years could be costly. Up-front and annual fees also eat into potential returns. This particularly applies with specialist lenders. As projects get bigger or more difficult, so does the complexity of loans. But with that comes vital elements of flexibility and speed.
The property industry is based on a wide base of small developers that need swift decisions or they miss out on deals. ‘Good opportunities don’t hang around,’ says Nicholas Warren, sales executive with Regentsmead, which is working with around 50 builders across the South at any one time. One recently asked for £100,000 on a Monday to buy a dilapidated cottage and received the go-ahead by Thursday. Another borrowed £30,000 to take development to foundation level when planners stepped in and demanded further work. He was left needing an extra £25,000 to pay sub-contractors and got it the same day.
That is because a principal lender like Regentsmead is using its own money and insists on close personal contact, so it can make swift judgements. But specialists are not for amateurs and dabblers. Firstly, development finance usually needs to be repaid much faster and cost more. Regentmead lends up to £2m over six to 12 months at fixed monthly interest of one to 1.5%, although this is charged only what is drawn down. Borrowers are normally expected to meet 50% of site acquisition costs then it usually provides the balance together with 100% of construction costs.
‘We also look for people who know what they are doing,’ says Nick Barrett, a director of Heritable Bank, another specialist. ‘Preferably, they have been through a downturn and come out the other side.’ In return, borrowers get the benefit of long experience of the market plus loans tweaked to the needs of complex projects. Development is rarely straightforward and finance needs to reflect this. ‘Banks may provide the bulk of loans but these are dry, restrictive and unimaginative,’ says Barratt.
A typical Heritable facility ranges from £250,000 to £4m but no two are exactly alike. A developer may be assembling a site and need staged finance with delayed payback. Complex refurbishment problems may require flexibility to meet the unknown. Specialists can weigh up planning issues, highways demands and rights of light restrictions which may impact on new building and re-development, as well as make judgements on the ability of a borrower to carry through schemes. ‘Banks tend to tick boxes while we get out and meet people before making decisions,’ says Warren.
Investors face similar tests when making the step upwards from conventional bank loans. Specialist lenders generally aim at a minimum of £500,000 with the possibility of generating further business up to and above £1m. A track record helps because equity from a completed scheme can be ploughed into others.
They have little appetite for beginners as the time answering endless basic questions yields no reward. That is the role of brokers where the small print again becomes important, as they may take a fee from the lender, make an up-front charge to the client and also try to tie in extra costs such as insurance.