UK: Investing In Commercial Property For Charities

Last Updated: 8 November 2007

Article by Rod Ross

Rod Ross is a director of Goodman Property Investors, one of the UK’s largest property fund managers. Rod Ross outlines how charities can benefit by investing in the commercial property sector.

The commercial property sector has had three years of exceptional returns averaging 18.7% per annum. These returns have been driven largely by increased investor appetite for the asset class and, in no small part, freely available debt finance. However, it appears the bull run is now over and more modest returns lie ahead.

At this stage in the market cycle a number of questions may be asked.

  • Why invest now?
  • Are future returns attractive?
  • What advantages does property as an asset class offer to charity investors?

Income And Capital Returns

A distinguishing feature of property investments is rental income. This is generally fixed on a contractual basis and paid in advance at regular intervals, usually quarterly. Returns from property investments therefore have two components:

  1. Income
  2. Capital growth

While in periods of high performance capital growth will comprise the major component of returns, it is the income element which differentiates property as an asset class and defines the way returns respond to an unsettled environment. Property returns tend to be significantly less volatile than those of either equities or gilts, as illustrated in Figure 1.

Although the strength of the income stream from a property asset depends on the tenant’s ability to pay the rent, the contractual aspect of the rental income provides a bond-type characteristic. Indeed, properties let on very long leases to the Government or, for example, to FTSE 100 companies may, on occasion, be priced quite closely to equivalent redemption-dated bonds. Property investments also have the potential to provide capital growth and, consequently, can be regarded as a type of equity/bond hybrid, with returns expected to lie between the two, as shown in Figure 2.

SDLT Exempt

Property transactions in the UK incur Stamp Duty Land Tax (SDLT) and most commercial property investments will fall within the top band of 4%. Charities and certain specific pooled fund structures available only to charities are exempt from SDLT. On a typical property acquisition, the benefit to a charity is an additional income return of around 0.2%, giving a unique advantage.

Portfolio Diversification

A further benefit of property in an investment portfolio is the low correlation of returns compared to other major asset classes. Over the past 35 years the correlation between property and the stock market has been one third of the correlation between equities and gilts. Property can therefore be considered to have a strong diversifying effect within a portfolio.

At a time when income returns from investments are generally scarce, volatile, or, at worst, both, commercial property provides a reliable, predictable and growing income stream. Property leases typically have provision for the rent to be reviewed at predetermined intervals, usually three or five years. In the UK, these reviews are conventionally upwards only, effectively giving a ratchet effect to the investor’s income stream. The potential for rental income growth is therefore another factor unique to property, which is of particular attraction to an investor requiring an effectively inflation-proof income stream. Rental growth will also flow through into capital values and give a further boost to total returns.

Perhaps the most important distinguishing characteristic of property, compared with other investment assets, is the non-homogenous nature of the investments; every asset is unique and different. While this can prove problematic for a small investor wishing to ‘buy the market’, for large investors it provides not only a further level of diversification, but also potential to add value to the portfolio.

Active management of individual assets is a further opportunity for investors in property, which can provide an additional level of both income and capital returns. The portfolio manager should be acutely aware of differences between individual properties in each location and seek to maximise any advantage which can be gained from this. Asset management can take a wide variety of forms.

It might involve:

  • widening a planning consent to allow a greater variety of more valuable uses
  • upgrading, refurbishing or extending a property, discussing tenants’ requirements with them and negotiating changes to the leasing structure to increase the overall rent payable (perhaps most frequently).

Timing

Timing of management initiatives can be critical. To achieve a re-letting of a unit shortly before rent reviews fall due elsewhere within the property can create evidence allowing rent to be taken to a new level, far outstripping underlying levels of market rental growth. At the current point in the market cycle, successful management initiatives can provide a significant boost to overall returns. Choosing the best portfolio manager is therefore essential for gaining the optimum return from property.

Disadvantages of commercial property are the ‘lumpy’ size of individual investments and the time taken to achieve transactions. Due to the relatively large individual lot sizes of investments, it is difficult for small investors to build a portfolio which benefits from sufficient diversification to allow asset-specific risks to be managed. For these reasons, investors may well be advised to seek an appropriate investment fund by which they can pool their resources with other investors to achieve a more attractive critical mass and sufficient diversification.

Maximising Benefits

By carefully selecting a manager, the investor can also hope to maximise the benefits of a programme of active asset management. Unfortunately, despite the plethora of available funds, both openended and closed-ended, investing in commercial property, very few either have charitable status or are reserved exclusively for charity investors. Without benefiting from their SDLT exemption, investors will lose a valuable additional boost to their income. However, choosing a fund for its charitable status alone may not provide the additional management boost which maximises the benefits of the asset class.

At a time when many charities are seeking to extract ever-greater income from their investments, the income return from property is higher and more stable than from other asset classes. It is also capable of being proactively managed to create extra returns. A carefully selected portfolio can provide an attractive level of income with potential for capital growth, while retaining a diversified spread of asset types. The years of plenty may be over for commercial property for the moment but for many, the attractions of a predictable, growing income stream, supplemented by skilful management, will provide an attractive addition to a portfolio.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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