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IPF Investment Property Forum Understanding Commercial Property Investment A Guide for Financial Advisers 2007 Edition i This guide was commissioned by the Investment Property Forum with funding from the Investment Property Forum Educational Trust, the RICS and the British Property Federation. The Investment Property Forum (IPF) has over 1,800 individual members drawn from a wide range of different professional communities including fund management, surveying, law, banking and accountancy. The Forum’s mission is to improve the awareness, understanding and efficiency of property as an investment, for members and others in the wider business community, including government, by: • • • Undertaking research and special projects Providing education Encouraging discussion and debate For further information on the IPF, visit: www.ipf.org.uk The Investment Property Forum Educational Trust is one of the leading promoters and supporters of education and research related to investment property as an asset class. The objectives of the Trust are the advancement of education in connection with the financing, development, management, valuation, ownership and marketing of land, property and buildings, as well as other general charitable purposes. For further information, visit www.ipf.org.uk The British Property Federation (BPF) is a long established and well respected trade association, which has achieved a considerable degree of success in representing to government the interests of the property owning and investing industry. Its mission is to sustain and promote the interests of all those who own and invest in property in the UK. The key feature of the BPF’s strategy is to persuade the Government that the property industry is a vital component of a successful economy and also an important route by which the Government can achieve the delivery of many of its key policy objectives: particularly urban regeneration, social inclusion, entrepreneurial success, savings and pensions reform and environmental improvement. For further information, visit www.bpf.org.uk The Royal Institution of Chartered Surveyors (RICS) is one of the most respected and high-profile global ‘standards and membership’ organisations for professionals involved in land, valuation, real estate, construction and environmental issues. It has: • • • • • • 136 years of representing property professionalism 110,000 members across 120 countries worldwide 300 degree level courses approved worldwide 500 research and policy papers published per year 50 national associations, linked groups and societies 160 diverse ‘specialisms’ – represented across 16 ‘faculties’ Accountable to both members and the public, the RICS has four main roles: • To maintain the highest standards of education and training • To protect consumers through strict regulation of ethics and standards • To advise global organisations, governments and regional boards • To publish market information and research For further information, visit www.rics.org.uk This guide is also supported by Investment Property Databank (IPD). Set up in the UK in 1985, IPD is now the world leader in real estate performance analysis. IPD produces benchmarks, market indices and detailed research. Reporting and analysis from IPD helps players within the real estate industry, from investors to occupiers, get the most out of their property. IPD now operates in over 20 countries including 15 European Union members, the US, Canada, South Africa, Australia, New Zealand and Japan and continues to expand its global reach. For further information visit www.ipdglobal.com ii Do you know the top performing asset class over three and five years? Are your clients looking to diversify risk in their portfolios? Which asset class delivers stable and relatively high income yield? What products give your clients access to these attributes? Individual investors are increasingly interested in commercial property. The recent ups and downs of the equity market highlighted the benefits that real estate can bring in diversifying a portfolio, and property’s stable income flow is attractive to those worried about the adequacy of their pension provisions. In response, a growing number of financial institutions and other product providers are devising commercial property funds targeted at private investors. If you would like to offer advice to your clients on these products, you need to understand the attributes of commercial property as an investment class and the mechanics of the market. An overview of the commonly available product structures is also crucial, not to mention some insights on the associated risks, the tax implications and regulatory considerations. This guide is designed to provide this information from a reliable and unbiased source. It is essential reading for all financial advisers including independent financial advisers, private bankers, wealth managers and pensions managers. Contents 1 1 Introduction 2 6 How can individuals invest in commercial property? 18 2 The commercial property market 3 UK authorised property unit trusts 18 How big is it? 3 Unauthorised property unit trusts 18 Who are the investors? 3 Unit linked life and pension funds 19 Other key players 5 Life bonds 19 Property types 5 Real estate investment trusts 19 UK property companies 21 Investment trusts 21 Offshore UK-listed property companies 22 Offshore investment company with variable capital 22 UK limited partnerships 22 Derivatives 23 Direct investment 24 SIPP investment 24 Property syndicates 25 3 Commercial property as an asset class 7 Commercial vs residential 7 What commercial property offers 7 4 How the commercial property market works 10 Ownership and lease structures 10 Buying and selling 11 Valuation 12 7 The risks 26 Indices and performance measurement 12 Property risk 26 Market risk 26 Product risk 27 Tax risk 29 Sources of further information 30 5 Investing in commercial property: some initial considerations 14 Regulatory context 14 What is available for private investors? 14 Some initial considerations 15 Risk 15 Diversification 15 Fees and costs 16 Tax 17 1 Introduction 2 Until recently, commercial property has been the domain of institutional and professional investors. Today, it is attracting widespread interest from individual investors. The volatility of the equity market has highlighted property’s benefit in diversifying a portfolio, while its stable and secure cash flow appeals to those concerned about providing adequately for their retirement. As a result, financial institutions and other product providers are structuring commercial property funds targeted at individual investors. And, from 1 January 2007, real estate investment trusts offer investors a tax-efficient corporate vehicle. These trends present new opportunities for investors and their advisers. However, indirect investment in commercial property is not straightforward. It is important that financial advisers, private bankers, wealth managers and pensions managers appreciate fully not only the opportunities but also the risks. That way, they will be able to provide the highest quality advice to their clients. Commissioned by the Investment Property Forum and funded by three leading property industry bodies – the Investment Property Forum Educational Trust, the British Property Federation and the RICS – this guide aims to raise financial advisers' understanding and knowledge of commercial property investment by: • Describing the commercial property investment market, in terms of size, main property types, and key players • Setting out the main features of property as an investment in the context of other asset classes • Examining how the market works in terms of ownership structures, the transaction process, valueadding activities, valuation and performance measurement • Examining some of the key issues that financial advisers should be aware of when considering whether a commercial property investment product is suitable for a client • Providing details on the different ways that individual investors can gain access to commercial property • Examining the risks associated with commercial property investment so that financial advisers are better placed to inform their clients about the kind of risks they may be taking on Readers should note that this guide was originally published in December 2003, but it has since been revised to reflect the legal, tax and regulatory frameworks prevailing in December 2006. Also, it relates to the UK, but it has been written primarily from the legal perspective prevailing in England and Wales. Different legal regimes operate in Northern Ireland and Scotland. Reita – The REITs and Quoted Property Group For financial advisers who wish to find out more about the quoted commercial property investment market, we recommend that they visit the website www.reita.org Reita has been created by The REITs and Quoted Property Group to provide an impartial source of expert information on quoted property investment and REITs. The group is funded and supported by leading companies in the property and financial services sectors including the British Property Federation and the Investment Property Forum. 2 The commercial property market 3 How big is it? There is about £762bn of commercial property in the UK. In comparison, the private residential market is valued at £3,400bn, while the equities market – as measured by UK companies quoted on the London Stock Exchange – is worth £1,781bn*. The core sectors of commercial property – shops, offices and industrial – account for about 80% of the market, £609bn. Around half of this is investment property, that is, rented to tenants by landlords. The remainder is mostly owned by occupiers, mainly private companies and, to a lesser extent, public sector and non-profit organisations. The proportion of investment property is gradually rising as owner-occupiers release the capital tied up in their buildings by selling them to investors and taking a leaseback. For example, food retailers Tesco and Sainsbury’s have both done this with some of their supermarkets and distribution centres. The Government, too, has arranged sale and leasebacks for large packages of its property, including the Ministry of Defence’s housing stock. Who are the investors? As the pie diagram shows, a wide range of organisations and individuals invest in UK commercial property. Financial institutions UK insurance companies and pension funds together hold the largest block of investment property, 28%, as portfolios of directly-owned real estate. These institutional investors also have large indirect holdings via their stakes in unitised and pooled funds, property unit trusts and limited partnerships. In total, they own an estimated 40%, by value, of the core commercial investment stock. UK property companies There are 114 quoted property companies in the UK. Currently they hold around 14% of the UK’s investment stock. However, this sector is likely to dwindle with the introduction of REITs, a new tax-efficient quoted corporate vehicle, in 2007 (see p19). There are also over 3,300 private property companies. These range from the very large to small ones that own a single property. Investors in UK Commercial Property Other Investors 3% UK Private Investors 3% Property Unit Trusts 4% Traditional Estates & Charities 5% UK Institutions 28% Overseas Investors 15% Limited Partnerships 7% Unitised & Pooled Funds 4% UK Private Property Companies 15% *Estimate for end-2005, based on research undertaken for the IPF by Cass Business School, DTZ and Investment Property Databank. UK Listed Property Companies 14% T H E C O M M E R C I A L P R O P E RT Y M A R K E T 4 Overseas investors Limited partnerships and unit trusts Foreign investors are now a significant force in the UK. They own about 15% of the commercial property investment stock, and according to DTZ’s Money into Property, they spent £12bn buying UK commercial real estate in 2005. Typically, these overseas buyers are looking to enhance their returns and/or diversify their risk by investing outside their domestic property markets. Limited partnerships have been the indirect vehicle of choice for many investors. Not only are they tax transparent, but they also provide specialist management and/or access to a pool of assets in a particular market sector. Moreover, limited partnerships often use debt finance. This makes them particularly attractive to institutional investors, who may only make limited use of gearing when investing directly. However, other factors besides returns and diversification can influence their choice of the UK. For example, in recent years, Irish syndicates have been particularly active investors here. According to DTZ’s monitoring, in 2005 alone, Irish investors purchased £2.8bn, or 22% of all foreign spending on UK commercial real estate that year. Clearly, they are attracted to UK property by its performance prospects and because the yields offer a margin over their finance costs. But the UK’s familiar lease structure, geographical proximity and common language are also factors that appeal to Irish investors. Traditional estates and charities Traditional estates such as Grosvenor, Portland, Cadogan, the Crown and Church Commissioners, together with charities and charitable trusts, account for 5% of the market. However, the Finance Act 2004 introduced Stamp Duty Land Tax provisions that affected both the value and liquidity of limited partnership interests, particularly those using debt. Consequently, institutional investors are now keener on offshore property unit trusts. Usually based in the Channel Islands, these PUTs offer tax efficiencies as well as some liquidity in units (see p18). As the chart below shows, institutions, listed property companies and traditional estates/charities are making more use of these vehicles, and the proportion of real estate that they hold indirectly has grown significantly over the last seven years. Indirect Investment % Private investors In recent years, private investors’ interest in commercial property has sharpened because of the volatile equity market and worries over the adequacy of their pension provisions. However, because direct investment in commercial buildings requires relatively large amounts of capital, most private investors have opted for buy-to-let residential property. But increasingly, financial institutions and other product providers are launching commercial property vehicles for smaller investors. So far, most have targeted high net worth individuals and ‘sophisticated investors’. 12 10 8 6 4 2 0 1998 Source: IPD 1999 2000 2001 2002 2003 2004 2005 T H E C O M M E R C I A L P R O P E RT Y M A R K E T 5 Other key players Developers Developers play a key role in assembling sites, organising the services of specialists, and finding the finance to produce a building or bigger complex. Where development is undertaken speculatively, that is, without a contractual commitment from a tenant, the financial risk can be significant, but then so can the rewards. Many investors also develop on their own account or through joint ventures to create the stock for their portfolios and to enhance their returns. Institutional investors will often share an element of risk with a developer by committing to acquire a building either before construction commences or part way through the process. By contracting to buy the scheme, sometimes before a tenant has been found, the investor makes it easier for the developer to secure finance for the project. Chartered surveyors and property consultants There are about 20,000 firms of chartered surveyors and property consultants in the UK. They provide a range of services, including: • Marketing properties available to lease, identifying suitable occupiers and negotiating leases for clients • • Negotiating the purchase of properties • • • Managing property for investors Surveying properties and reporting on their condition and structural soundness Valuing property Marketing property for vendors The Royal Institution of Chartered Surveyors is the professional body that ensures the competence and maintains standards of its members. Bankers Property types As well as providing development finance, bankers also lend to a wide range of investors who want to leverage their equity with debt. According to De Montfort University’s latest research, there was over £156bn of loans outstanding on commercial real estate at the end of 2005. Investment property accounted for 75% of this and developments for 13%. The largest borrowers, accounting for two-thirds of the total, were private property companies. The three principal sectors of the commercial investment market are retail (shopping centres, retail warehouses, standard shops, supermarkets and department stores); offices (standard offices and business parks); and industrial (standard industrial estates and distribution warehousing, or logistics facilities). In addition, there are several smaller sectors such as leisure (leisure parks, restaurants, pubs and hotels), student accommodation and healthcare properties. Occupiers A complete and reliable breakdown of the UK investment market by both sector and region is available only for the £192bn of mainstream institutional property that is monitored by Investment Property Databank. It covers only the three main sectors as the charts overleaf show. The commercial property market places considerable emphasis on the financial strength – the covenant – of an occupier. This, along with the lease terms, is critical in assessing both the risk in, and the value of, an investment. Thus, developers want to let their schemes to good occupiers, that is, tenants with good covenants, to maximise the value of the building. Investors assess potential occupiers’ covenants by examining their financial accounts or using credit rating agencies, such as Dun & Bradstreet. • London and the South East have the lion’s share of commercial property investments • Retail property is more evenly distributed across regions than offices or industrial. Shopping centres, retail warehouses, department stores, supermarkets and standard shops are found in most towns of any size throughout the country and, with the exception of standard shops, come in large lot sizes T H E C O M M E R C I A L P R O P E RT Y M A R K E T 6 Regional Distribution of Retail Investment Property Regional Distribution of Industrial Investment Property North East North East Wales Wales East Midlands East Midlands Scotland Scotland West Midlands Yorks & Humber Yorks & Humber South West Eastern North West North West West Midlands South West Eastern South East London London South East 0% 5% Capital Value (%) 10% 15% 20% 0% Number of properties (%) Source: IPD • The office market is heavily skewed towards London and the South East. London alone accounts for more than 66% with concentrations in the City and West End • Industrial property is also concentrated in London and the South East 5% Capital Value (%) 10% 15% 20% 25% Number of properties (%) Source: IPD Regional Distribution of Office Investment Property North East Wales East Midlands Yorks & Humber North West West Midlands Scotland South West Eastern South East London 0% 20% Capital Value (%) Source: IPD 40% 60% 80% Number of properties (%)