Property is an important part of our everyday life. It’s where we live, work, shop and much more. But it can also offer a good investment opportunity, particularly as a way to generate income.
Here we look at what property investing covers, how you can invest, and the benefits and risks. If you want to know more than just the basics, we also take a closer look at some of the more technical details, including how property is valued, the importance of yields and real estate investment trusts (REITs).
What property investing covers
Investing in property can be as simple as owning your own home. It can also involve buying residential property to let out. But typically in the investment world, property investing refers to commercial property – in other words buildings and land used by businesses, and this is what we cover in this guide.
There are three main types of commercial property:
- Retail property
Shops, shopping centres and retail parks
- Office property
Offices and business parks
- Industrial property
industrial estates, warehouses and factories
The leisure and entertainment sectors also provide investment opportunities, for example hotels, restaurants and cinemas.
How you can invest in commercial property
There are high costs involved with buying and managing commercial property. So most people invest via one or both of the following routes – each of which has its own benefits and risks:
- Direct property funds
This is where you put your money into a fund that invests in a portfolio of properties. A fund manager will choose where to invest and manage your money on your behalf, pooling it with other investors. This means you benefit from the fund manager’s expertise and knowledge of the property market, greater diversification and economies of scale. But remember that all investments can go down as well as up in value.
- Indirect property investments
This is where you invest in the shares of companies that own, manage or develop property, or in a fund that invests in a range of property companies. Investments of this type share similar characteristics with equity investments. So although they offer good growth potential, they also tend to be more volatile than other types of investments - see the ‘Getting technical’ section below for more information about one popular type of indirect property investment – real estate investment trusts (REITs).
You can also choose funds which have a range of investments, including commercial property. This could be a good option if you’re new to investing or simply don’t have the time to build and manage your own investment portfolio.
The benefits and risks of direct property investment
- It’s a way of balancing out risk
Historically, commercial property has performed differently to other asset classes, like equities and bonds. So it can be a good way of diversifying your overall investment portfolio and balancing out the risks of the other asset classes.
> Find out more about why it's a good idea to have a diversified range of investments
- It can provide a regular and long-term income
This is usually the main source of returns from commercial property investments, and it comes in the form of rent paid by tenants. Commercial property leases tend to be longer than for residential property, meaning you have more certainty about receiving a regular stream of income for a longer period of time.
- You can get steady long-term returns
Like other asset classes, the value of commercial property can go down as well as up and may be worth less than was paid in.
But, over the longer term, commercial property has been less volatile than equities, while still providing good returns.
Past performance is not a guide to future performance and investment returns aren't guaranteed.
But one of the main downsides is that, like residential property, commercial property can take a lot longer to sell than other types of investment and its value is based on a valuer’s opinion of what it’s worth. That means it can’t always be sold when it needs to be or at the price wanted. This can be a problem for direct property funds if a large number of investors want to take out their money at the same time.
When this happens, fund managers can impose restrictions on investors taking money out to give them an opportunity to sell properties for the best possible price and to help protect the value of their funds for all investors. In some cases, investors may have to wait months before they can take their money out.
This happened during the financial crisis of 2007-09 and again following the UK’s referendum to leave the European Union in 2016. So it’s important to be aware before investing in direct property funds that there may be times when you can’t access your money immediately.
Read on for more information about the commercial property market and REITs.
Commercial property ownership
Like residential property, most commercial property is either available on a freehold or leasehold basis. If someone has the freehold on a property, it means they own it outright. If they have a leasehold property, it means they have the legal right to that property for a set period of time.
Properties with long leaseholds can have very similar values to freehold properties. But, as the length of a lease falls, so will a property’s value.
How commercial property is valued
The comparative methodThis is the most widely used method and involves making a valuation by comparing the property directly with similar properties that have been sold.
The investment method
This is where a property is valued based on the level of rental income it can generate. Generally, the better the level of rental income, the higher the value of the property.
The profits method
In some cases there might not be any direct comparisons when valuing a property, for example in the case of theatres, hotels or restaurants. in this case the valuation is made by looking at the potential profits of the business using the property.
There are three main methods that can be used when valuing commercial property:
Property yields – what they are and why they matter
You’ll often hear the term ‘yield’ used in connection with commercial property investments. It’s important not to confuse this with the amount of rental income a property generates.
A property’s gross yield is the yearly return on a property expressed as a percentage of its value and it’s calculated as follows:
Yearly rental income DIVIDED BY Property value
The net yield is the yearly return on a property after all expenses, including things like purchase costs, management fees, maintenance and repairs, rates and insurance, have been taken into account. So it’s a more realistic reflection of the actual return on investment. Here’s how it’s calculated:
(Yearly rental income MINUS Expenses) DIVIDED BY Property value
Let’s take an example of an office block that’s valued at £1.5 million and generates a yearly rental income of £100,000.
Gross yield: £100,000/£1.5m = 6.7%
Now take into account expenses of £20,000.
Net yield: (£100,000 - £20,000)/£1.5m = 5.3%
Yields are important as they give an indication of the return you can expect on an investment and can be a good way of comparing properties when deciding where to invest. However, it’s important to understand that in a strong property market, yields are likely to fall, and vice versa.
Real estate investment trusts (REITs)
Most of the UK’s largest property companies have become what’s known as a REIT since they were launched in this country in 2007. To become a REIT, at least 75% of a company’s profits must come from property rental and 75% of its assets must be involved in property rental. REITs also have to pay out 90% of their property rental income to their shareholders as dividends. In return for these fairly stringent restrictions, REITs don’t pay any corporation or capital gains tax on the properties they invest in.
For investors looking for a source of income, the high level of dividend payments is attractive. Many REITS also have long lease agreements with their tenants, which means a relatively stable income stream. But, as REITs pay out so much of their profits as income, they don’t have much left to reinvest in new properties and so expand as a company. If they want to do this, they either need to borrow money or create new shares.
Creating new shares has the effect of reducing the capital value of existing investors’ holdings, while an increased level of debt can be an issue if a downturn in the property market adversely affects rental income levels. So although REITs can be an attractive investment option, it’s important to be aware of their risks too.
- Types of REITs
There are REITs which own a wide range of property types, as well as REITs that focus on particular segments of the market, such as healthcare or retail.
REITs aren’t unique to the UK. They originated in the US back in the 1960s and have now spread to many other countries around the world, including France, Germany, Canada, Australia, India, Japan, Brazil and South Africa.
- How you can invest in REITs
As with any company that’s listed on a stock exchange, you can invest in REITs directly, or through funds.
This information is to help you understand more about commercial property and why you might want to invest in it. Please remember though that the information here shouldn’t be regarded as financial advice. The value of any investment can go down as well as up and may be worth less than was paid in.