After some massive swings, the FTSE 100 is pretty much back to where it was before the financial crisis.
But there’s one asset class where prices are still 30% below their peak in 2007. I’m talking about commercial property.
The nice thing about commercial property is that it’s normally less volatile than stocks – partly because it’s more often bought for the income it can provide, rather than the capital gains. That makes it worth considering as a way to diversify your portfolio.
What’s more, ‘upwards only’ rent reviews normally mean that you get a nice, rising income.
So is now a good time to invest in the sector?
Commercial property prices are on the up
Commercial property is a catch-all term to cover all property used for business purposes. So we’re talking shops, offices and warehouses in the main.
Having had a rough time during the financial crisis and recession, rents and capital values for the sector as a whole are now rising again.
The latest figures from the Investment Property Database (IPD) show that rents for all UK commercial property rose by 0.1% in November. That may seem relatively modest – it is – but it’s the biggest rise since 2008. It’s also the third consecutive month of gains.
Meanwhile the average capital value, across all commercial property, rose by 0.9% in the month of November alone, with prices up 2% on the year.
And there’s a fair bit of evidence that suggests we’re going to see further rises over the next couple of years.
First, there’s the obvious point that the economy is picking up. That’s good news for business in general, which means fewer companies struggling to pay rents and – in the longer run – more demand for property as new businesses start and others expand.
Secondly, valuations look reasonable. According to IPD, the average yield on UK commercial property is 6.18%, which is way higher than the average yield on the FTSE 100 – currently around 3.75% – and a lot higher than gilts. True, I’d normally expect the yield on property to be higher than that on equities, but a premium of almost 2.5% is pretty tasty in the current low-yield environment.
Developers are also becoming more upbeat about prospects for the sector, feeling more confident than they have for more than six years.
On top of that, banks seem to be moving more quickly to clear up some of the mess in their commercial property loan books. Net lending for existing property fell at the end of last year.
Lending fell? Isn’t that bad news? It sounds like it, but as Capital Economics notes, it’s actually a good thing. Why? Well, the banks didn’t dare foreclose on their bad loans a couple of years ago, because they knew that property valuations were weak. They also feared the impact on their balance sheets.
If they’d acknowledged the amount of money they’d lost on bad loans, they’d have been bankrupt themselves (as MoneyWeek regular writer James Ferguson regularly points out).
But now that things are picking up, the banks are willing to take the pain. And once the banks have dealt with their bad debts, they will be more confident about making new loans. In fact, Capital Economics reckons the “distressed debt work-outs” could come to an end later this year and then we could see a “modest pick-up in lending”. That should push up valuations in 2015.
How to buy commercial property
Don’t get me wrong, I’m not suggesting that everything is perfect and commercial property is a one-way bet. Even though overall valuations seem reasonable, the West End market looks a little frothy, with some buildings now going for £100 per square foot.
I also worry a bit about retail property across the UK. Demand remains strong for large flagship shopping centres such as Westfield in London, but your average high street isn’t exactly buoyant.
On the other hand, it’s not as if this is news. You can’t move for celebrity taskforces trying to ‘save’ the high street. So you can make a good case that the downside for retail properties is already ‘in the price’.
Anyway, the high street isn’t completely down and out. It may be changing shape, but there will still be demand for cafes, restaurants, and some traditional shops in ten years’ time.
If you’re tempted to invest, the most obvious approach is to go for one of the big property Reits (real estate investment trusts). Most Reits are long-standing property businesses that benefit from sizeable tax breaks.
I’m not expecting stunning returns from here, but if you want to diversify your portfolio, and are prepared to think long-term, there are still decent yields available.
Rising interest rates may represent a threat, but you could say that for almost any sector right now. In any case, the Bank of England is determined to keep rates low until it is absolutely sure of the economic recovery – so it’s possible that rates may not move as quickly as the market fears.
I particularly like British Land (LSE: BLND) which has a diverse portfolio and pays a decent 4.3% yield. But if you’d prefer to focus more on the London property market, Derwent London (LSE: DLN) could be a good bet. The company has done very well redeveloping offices in areas that are moving upmarket such as Fitzrovia and Shoreditch.
On the riskier side, there’s New River Retail (LSE: NRR). It’s risky because the company focuses on shops and smaller shopping centres. Most of its tenants are either food stores or ‘value’ retailers such as Wilkinsons or TK Maxx.
But the attraction lies in a yield that’s above 5%, and a management team with a fine record. If you think the doom and gloom on the high street is overblown, you could do well here.
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