Why you should avoid commercial property

The Bank of England may have kept interest rates on hold this month, but the bias remains towards increases. And that's bad news for one particular asset class.

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The Bank of England decided to let householders rest easy over the Easter weekend.

We'd predicted the Bank would raise interest rates, but it's clearly decided that one big surprise this year was enough for now, and is waiting for May's quarterly inflation report before it decides on its next move. So for the moment at least, it looks like we can expect a hike next month.

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In any case, there's no doubt that the bias remains towards higher rates. And that could be bad news for one asset class in particular...

Interest rate rises are of course, a worry for the residential property market. But another massively popular asset class, commercial property, is also at risk from monetary tightening.

Writing in The Telegraph yesterday, Roger Bootle of Capital Economics posed the question: "is the UK commercial property market a bubble waiting to burst?"

In the past ten years, commercial property prices on average have doubled. "Commercial property has been a very hot sector indeed." All through last year, it was the top investment sector for private investors, and fund houses across the land have been falling over themselves to take advantage of demand by launching new commercial property vehicles.

As Bootle points out, six or seven years ago, commercial property was a good buy, offering a decent yield over and above that available on equities or gilts - hence the surge in values. But of course, as always happens, people see prices go up, then jump on board the bandwagon, driving them even higher.

These days, rental yields on commercial property are actually below those on gilts, which are the closest thing to a no-risk investment you can get. In other words, investors in commercial property already get 'less of an income return... than they do from gilts - despite the much greater risks.'

Gilt yields are already historically low, and with the base rate looking set to rise, they are more likely to rise than fall in the year ahead. So for commercial property investors to have any hope of a decent return, rents have to rise. But as Bootle, says, strong rent rises are unlikely too. "There is a fair amount of unused commercial property available and commercial property construction has been high."

There are other serious structural threats to the market. It's now just over a year since the Dixons brand vanished from the high street and onto the internet. While opinions on the success and wisdom of the transition have been mixed, the travails of other specialist retailers like HMV show that maintaining a branch network for products which are cheaper and easier to buy online is set to be a thing of the past.

Companies simply can't afford the overheads. The costs of paying rent, rates and wages to maintain and staff a high street branch have to be reflected in the selling price of the in-store products. If your internet-based competitor has just a warehouse and a call centre to run, then it can afford to offer cheaper goods while maintaining healthier profit margins. That's an entirely unsustainable level of competition.

And it's not just specialist retailers. They might be the first to go, but other sectors are ripe for following them online too. The banks aren't overjoyed at having to keep all those local branches open for a start. They may have retreated from high-profile mass closures in the face of a consumer backlash, but there's no doubt that they would rather migrate more business onto the internet - particularly now that they'll be looking for more areas in which to cut costs as the regulator cracks down on penalty charges.

Whether this means we can look forward to high streets filled with cafes and street markets, or derelict premises covered with graffiti, only time will tell. But we don't think it will be that long before we start to find out.

Mr Bootle reckons that there will be a "petering out of the boom in commercial property but no bust, at least as long as values are not carried much higher than they currently are."

But to his credit, he points out that he's not at all sanguine about this viewpoint. "The end of the good times usually brings some sort of nasty shock." As he warns, "commercial property used to be regarded as risky but now investors seem to think it is safe. They could be in for a shock."

Of course, commercial property's not the only asset to have been buoyed by cheap money almost everything from art to fine wine has seen massive price inflation. So in a world where rates are rising, most investments look vulnerable.

Regular MoneyWeek contributor Tim Price recently wrote a cover story for us about how to protect your wealth in an increasingly uncertain world - subscribers can read it online here: How to protect the money you've made.

(By the way, if you're not a subscriber, you can click here for a three-week free trial: /file/194/subscribe-from-not-logged-in.html)

Tim has a new email investment advisory service coming out very shortly - we'll be sending you an email later today with more details - look out for it.

Turning to the stock markets

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The FTSE 100 closed higher ahead of the long weekend on Thursday, gaining 32 points to end the day at 6,397, as the likes of Old Mutual and Intercontinental Hotels were boosted by positive broker comment.

Across the Channel, the Paris CAC-40 closed 2 points higher at 5,741 and the Frankfurt DAX-30 closed 26 points higher, at 7,099.

On Wall Street, US stocks closed marginally higher yesterday as the Dow Jones notched up its seventh straight session of gains. The industrials index closed 8 points higher, at 12,569. The tech-heavy Nasdaq closed 2 points lower, at 2,469. And the S&P 500 rose a fraction of a point to close at 1,444.

In Asia, the Nikkei closed 79 points lower, at 17,664 today.

Crude oil had edged up to $61.71 this morning. In London, Brent spot was over a dollar lower, at $67.44.

Spot gold was at $676.60 today and silver was at $13.83.

And Madrid-based tobacco stock Altadis SA rejected a revised takeover bid from Imperial Tobacco today, stating that the 12bn euro evaluation was still too low. Imperial's stock had fallen 20p to 2,243 this morning.

And our two recommended articles for today...

Is there any alpha left in private equity?

- According to the experts, private investors can never achieve alpha because they can never know as much as the market itself. Yet private equity is currently offering investors a tantalising opportunity of just that. For Bill Bonner's take on whether such offers of market beating returns are too good to be true, read: Is there any alpha left in private equity?

Six reasons why gold still looks good

- MoneyWeek article: A combination of favourable conditions means that gold could rise as high as $1500/oz in the next few years. To find out why the future looks bright for gold - and how to invest accordingly click here: Six reasons why gold still looks good

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.