What does “commercial property” actually mean?
In investment terms, the property world divides roughly in two – the house or flat you live in is classified as “residential” property, while shops (“retail”), offices and industrial premises, such as warehouses, are all labelled as “commercial”.
Unlike a house, which most people buy direct with, or without, the help of a mortgage, virtually all private UK commercial property investors get access either by buying into a property fund – structured as a unit trust or OEIC – or by buying shares in one of the giant listed investment trust companies, such as British Land (BLND) or Land Securities (LAND).
Between them, the latter own around £31bn of commercial property assets, according to The Times, including – in Land Securities’ case – trophies such as the huge neon signs that light up London’s Piccadilly Circus.
How’s the commercial property sector doing now?
Badly. British Land was forced to pull the £1.64bn sale of its flagship Meadowhall shopping centre in Sheffield last month and has seen its share price almost halve since January.
And Land Securities, a firm described by one analyst as a “bellwether – something grannies in Bradford could buy”, confirmed plans for a break-up that would split the business into three smaller ones (focused separately on London, retail and the outsourcing work handled by its Trillium division) in what many see as an attempt to bolster a plummeting share price.
The storm is not just lashing these two, though – the Royal Institution for Chartered Surveyors warned this month that 2007 would be the first year in fifteen in which total commercial property returns have fallen, while an increasingly anxious Bank of England has cautioned that the sector is “particularly prone to further shocks”.
Why is it all going wrong?
Because a once-mighty bubble has just popped. Formerly viewed as a relatively fringe area for most private investors, by 2006 commercial property fund managers were attracting more new money than anyone else. This wall of cash was supplemented with cheap debt when interest rates were low, driving up prices for a finite number of developments.
Recently, however, due to five interest-rate rises from the Bank of England, combined with the tightening of credit terms and general risk aversion caused by the US-led crunch, funding costs have jumped just as commercial property prices, driven up for years by huge investment flows, have peaked.
So will we see a new commercial subprime crisis?
There are certainly some alarming parallels with the troubled US residential market. Commercial property has spawned its own brand of mortgage-backed securities, which, according to the Federal Reserve, account for 27% of all commercial mortgage loans, up from just 4% in 1990, and yields – a measure of risk – have soared this year to decade highs.
The problem, as the FT notes, is that just as standards in the residential mortgage market were relaxed to allow ever more reckless borrowing by individuals, so “underwriting standards declined” for commercial property.
By the third quarter of this year, for example, credit agency Moody’s estimates that the average loan was 118% of property value, generating leverage described by their head of research, Sally Gordon, as “really kind of creepy”.
On the flipside, the market for commercial mortgage backed securities, valued at around $800bn, is only one eighth the size of its residential counterpart, so any fallout should be more contained. And although both retail and industrial yields are under pressure, rents for blue-chip office developments, often underpinned by long leases, actually rose by 0.2% in October, says the IPD.
Why does all this matter for retail investors?
It doesn’t, provided commercial property is just a small part of your portfolio. But Mark Dampier of Hargreaves Lansdowne worries that too many private investors may have up to half of their investment portfolios in this asset class – bearing in mind that a commercial property fund can also be held in a pension plan such as a Sipp – and are thus heavily exposed to falling prices.
The hidden catch with commercial property, as opposed to, say, equities, is its “stickiness”. If too many investors try to cash in their investments at the same time a manager may be forced to sell property to fund redemptions.
This takes time in an illiquid, falling market, meaning your cash may not be returned for some time and you may lose more than you expected if prices keep falling in the meantime. And those who also have significant wealth tied up in residential property, particularly if funded by a big mortgage, could be in for a real battering.
Commercial property: what should you do?
If you are heavily invested in commercial property either within, or outside, a pension, consider reducing your exposure pretty soon. And although the market will eventually bottom out, as broker Charles Stanley comments, “sentiment is against the sector”, so this is no time for bargain hunting.
Yes, some real estate investment trusts are now trading at attractive discounts to net asset value and offer dividend yields of 6% or more – but to buy now looks too much like trying to catch a falling knife.
For the brave, who fancy trying to profit from falling share prices, you could use spreadbetting to ‘go short’ on the larger listed property groups, such as British Land, Land Securities and Hammerson (HMSO) – but remember this is risky, and always use a stop loss.