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An alternative to buy-to-let

Those who want to invest in bricks and mortar don’t have to be restricted to residential buy-to-let. Commercial property offers a good alternative

Buy- to-let property has been one of the hottest areas of investment in recent years, but there are signs that the boom could be ending as the latest of a series of reforms undermines the attraction of being a landlord. Since 6 April,  those who borrow to finance a buy-to-let property have only been able to claim basic rate tax relief against their mortgage interest, part of a three-year process of eliminating tax relief on mortgages altogether. At the same time, the Government restricted the amount of expenses that can be set against income from lettings. The net effect for many landlords will be a rise in their tax bill.

That comes on top of last year’s increase in stamp duty levied on the purchase of properties to rent, which increased the cost of buying buy-to-let properties. To add to buy-to-let investors’ woes, the banking regulator has issued guidelines that could make borrowing against rental properties more expensive. 

The changes are already having a marked effect on the buy-to-let market: the value of loans for this purpose in the final quarter of 2016 was 63% below the previous year, according to statistics from the Council of Mortgage Lenders, and the decline continued into this year. It predicts that lending to this market will decline both this year and next – a prediction borne out by landlord surveys, as well as by evidence of a tightening of banks’ lending criteria and a reduction in the amount of finance available for prospective buy-to-let purchases.

Commercial property is diversified and dwarfs the residential market

But those who want to invest in bricks and mortar don’t have to restrict themselves to residential property; commercial property dwarfs the residential market in size and offers a good alternative for those who want to diversify their portfolio across different asset classes. Indeed, given that most of us have a substantial proportion of our wealth tied up in our own home, many experts would advocate commercial property over buy-to-let as a better way of diversifying risk.

Investing in commercial property has a number of advantages. First is diversification. Different types of assets have different cycles, so the more variety investors have in their portfolio, the more they should be insulated from the peaks and troughs in one particular asset class. Matthew Brittain, an investment analyst at Sanlam, says that the performance of commercial property has traditionally had little correlation with equities, so adding some to an investment portfolio can increase diversification of assets, and so help to reduce the risk that all the holdings move in the same direction at once.

A second attraction is income. Brittain points out that UK property is generally let to occupiers on long-term leases with upward-only rent reviews. “That means the income from property is relatively stable with the characteristics of bonds,” explains Brittain. Bonds, which are effectively loans made to companies and governments, are popular with investors because the interest rate that will be paid and the time at which the loaned funds must be returned are contractually agreed up front.

However, rental income is not the only benefit of property investment. Just as houses and flats rise in value, so too does the value of commercial buildings; indeed, these capital returns have been an important component of the overall return in recent years.

And, while prices can fall as well as rise, any changes tend to be more gradual than the sudden shifts that can be seen in the stock market. “Property has been a good investment over the past 25 years, despite the financial crisis and other economic and political events,” Brittain points out.

The property market itself is relatively diversified. It can range from trophy offices in London to high street shops, and from out-of-town retail parks to large industrial warehouses – both in the UK and overseas. The returns on these different types of building will also behave differently, depending on factors like the state of the economy, the level of interest rates and their location.

Property investment funds with shares traded on the stock market

On the downside, buying and selling property can take months – something that can be an issue when the market falls out of favour or if investors want access to their money quickly. But Brittain points out that this liquidity issue can be resolved by using investment funds such as real estate investment trusts (REITs), which hold a range of sizes and types of property, but whose shares are traded on the stock market like any other company.

Full_page.jpgHe cites the aftermath of the Brexit vote, when property briefly fell out of favour, as an example of the advantages of REITs. While the turmoil in financial markets following the vote meant some property owners were forced to sell quickly and prices fell, “REITs were able to take advantage of that and some of them picked up attractive assets at good prices”.

Brittain says that Sanlam’s portfolios will generally include some exposure to property, usually through REITs, making it easy to switch between different types of REIT or to add or reduce exposure to property as appropriate.

Commercial property has performed well since the financial crisis as low interest rates and economic uncertainty sent investors searching for assets producing stable and predictable income.  That has pushed the price of property higher and the yield, which moves inversely with prices, sharply lower.

“Yields are quite low by historic standards, especially in the more attractive areas,” says Brittain.

Now, however, interest rates are gradually rising from their record low levels. The US has already raised its rates twice and while increases in the UK and Europe may still be some way off, the consensus is that the next move will be upwards. That means that the return on property over the next few years may be lower than it has been in the recent past – indeed, some of the indices which track the performance of properties are already indicating that the market may be cooling. 

“If interest rates increase, it will represent a bit of a headwind,” says Brittain. “But that is not to say that prices will not continue to move higher, particularly if inflation starts to rise as well.” Indeed, inflation can be good for property as investors view physical assets like this as a hedge against rising prices, while inflation also erodes the value of loans secured against it.

Adding value to the property

Commercial and retail property does share characteristics. Just as we can add value to our houses by refurbishing, extending and redecorating them, so commercial landlords will also invest in improving the condition of their offices and shops. This active management can help counteract the effect of a slowing market. “In an actively managed portfolio, it is always possible to add value to the properties by reconfiguring the space or otherwise improving the building to increase the yield,” says Brittain.

For investors, the key is to be clear what they are investing in. While the buy-to-let market may be vulnerable to tax and regulatory changes, which are unnerving investors, this has no bearing on commercial property. There is still a place for commercial property as part of a balanced, diversified portfolio.

Find out more

For more information about how property can play a part in your investment portfolio, please get in touch a wealth planner or portfolio manager.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.