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Is commercial property a good investment?

The Covid-19 lockdowns have greatly accelerated the property trends that were in play before the crisis hit. The lockdown is bad news for property overall.

The Covid-19 lockdowns have greatly accelerated the property trends that were in play before the crisis hit. The lockdown is bad news for property overall.

by
John Redwood

in Features

01.05.2020

This week the reality of the underlying economic weakness was reported to the UK stock market by two large companies. Royal Dutch Shell decided the outlook for oil was so tough they would make a large cut in the dividend, the first since the Second World War. Lloyds Bank decided to make provision for substantial additional loan losses to come, almost eliminating the entire first quarter's earnings. As expected, they will pay no dividend. RBS too has upped its provisions considerably.

Before Covid-19 tightened its evil grip on the economies of the advanced world, property had a lot to offer the investor. Income levels on good quality property in the main cities of the world were considerably higher than high-grade government bonds, with the added advantage that rents could grow as economies prospered. Rental income was also often higher than dividend income on decent shares. After the banking crash of 2008-9 people made good returns by buying and holding property.

Property as an asset class used to have the advantage that rent is a prior charge ahead of dividends. Tenants usually accepted their legal obligation to pay the rent, even when trading was poor. In the UK, the system was based around upwards only regular rent reviews, offering considerable income stability.

Property ownership offers the opportunity to redevelop a building and change use to maximise returns. Investors also have to accept that owning direct property means accepting a far less liquid investment than a quoted share. Investment is lumpy, requiring substantial wealth to have a risk spread of different types of properties in different locations. This can be partially overcome by buying units in a collective investment or shares in a REIT.

Some of these unwritten rules of property investment are being thrown away by the current crisis.   Rent reviews are often now brought forward in the UK to secure a decline in rent. Landlords are having to offer rent holidays or rent deferrals to keep tenants at all. The balance of power has shifted towards the tenants as there has been a collapse in demand for new space with so many businesses facing greatly reduced turnover or banned from working at all. The crisis is particularly tough on retail and leisure properties, because so much of these business sectors have been shut down.

There were some pronounced trends in property prior to virus that were a warning to property lovers. The remorseless rise of the online retailer was putting downward pressure on rents in all but the most heavily visited of shopping centres. There was talk of the need to shrink the less attractive High Streets.

Portfolio owners of commercial property were wanting to reduce their exposures to shops. In contrast industrial properties were attracting great interest. Properties that had before been mainly for industrial use with relatively low rents became an important part of the development of the online retail sector. They need plenty of well-located warehouse space to store, sort and despatch product to their growing customer base. In between were offices. Fashionable centres such as central London and Manhattan, New York commanded high rents, with more difficulty sustaining tenant interest and rental levels in more marginal locations.

The virus lockdowns have greatly accelerated these trends. Many weaker shops may not trade again or will only do so after financial reconstruction. They will demand lower rents and more favourable terms from landlords. In the best centres such as Bicester Village the property industry has benefitted from turnover related rents to capture some of the extra cash good retailers can generate in well-trodden locations. The industry may need to start offering turnover related rents elsewhere as a way of accepting considerably lower rents based on the true earning power of the shop in that location. Industry specialists are wanting to open conversations about what percentage of turnover is appropriate. Retailers may argue there is such an oversupply of retail space that the rent reduction will need to be large.

Many tenants want a rent holiday for the duration of the shutdown and may not accept the offer of a deferral. Governments are tending to sympathise with tenants more than landlords. Rental income is proving to be as unreliable as dividend income for those with portfolios concentrated in the weak areas of the property market.

Values of the properties in retail and leisure will fall. They are still often too high to make it worthwhile to buy them and convert to a different use. The High Streets remain too long and too many, offering an overhang of void and underused property.  There may also be some slackening of demand for office space to come. As companies think through how they will adjust to working with less social contact, they may adopt more homeworking and hot desking to cut their space requirements.

It is difficult to avoid the conclusion that the policies pursued to combat the virus are bad news for property overall. Just as with shares, the changes policy induces will accelerate trends already visible. Retail goes down, good quality warehouses will remain popular, and offices will require careful selection.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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