The more you pay for a commercial property investment, the less you are likely to make out it at least in the short term, and quite possibly long-term too.
For many investors, expected return is often measured against the sort of returns that are available elsewhere, but looking over your shoulder for what else is on offer is not the way to assess whether a property’s yield is correct. The correct way is to ignore yield and instead concentrate on evaluating property fundamentals. Yield is a function of purchase price. Price has little to do with value, being more to do with what the market will bear. Price is a risky approach to valuation. It presupposes a direct correlation between price and value. In a sentiment-driven momentum market, how much investors are paying for property now is only a reliable basis for future pricing if the momentum continues. The moment the momentum slows or stops, the more the value, based upon property fundamentals, shines through.
The difference between price and value may not be obvious, particularly to the inexperienced. Valuation is based on property fundamentals, themselves in a world of their own which means any assumptions you make about the investment and its potential should be confined to an understanding of those fundamentals. It is when the yield is compared to alternatives to property then property could be regarded as, for example, more stable, less volatile, and more secure.
An investor in property owns the building, not the tenant’s business. In business tenancy law, whether the tenant could afford to pay more is irrelevant. Other than for gauging likelihood of whether the rent and any other payments would be paid on time, the tenant’s financial standing, known as covenant, is irrelevant. Most investors do not see it like that. Most investors would rather have a property let to a well-known business than a non-entity. Investors pay handsomely for peace of mind; hence the starting yield or return on capital is likely to be less.
Yields that are low for reasons other than property fundamentals place a great deal of trust in investment sentiment continuity. A proposition priced at say 4% means that the investor would get his money back in 25 years. Anything could happen before then. Indeed, by virtue of the instability in the property market, that is mostly hidden from view, a lot can happen within a short time of completing the purchase.
There is no substitute for experience, which is why it is not until the legal interest in the property is transferred from seller to buyer that matters that did not show up in pre-contract enquiries become evident. Amongst those matters is one that is nothing to do with the seller but which is potentially more dangerous: namely, the buyer’s enthusiasm.
Property purchase is time-consuming. In England and Wales, property transactions are normally subject to contract. Even at auction, there is no commitment before fall of the hammer. To avoid losing interest during what for many feels like a boring process, the buyer stimulates a need for activity and progress with the thought of what the buyer is going to do with the proposition after completion. As the excitement grows, the less likely the buyer would find fault with the seller’s disclosures and/or any flaws in the investment reasoning. Exchange of contracts brings a sigh of relief as the pressure eases.
Frustrating as the conveyancing procedures can seem, nevertheless it is of benefit to buyers to not have to hurry for the sake of it. But not having their wits about them from the moment the proposition goes under offer to seconds before exchange of contracts is one reason buyers can come unstuck.
Short-term, the consequences of overpaying can be mitigated by getting rid of the investment as soon as possible, in the hope that momentum in the market would result in a profit or at least cover the costs of reselling. Amongst the long-term consequences of over-paying is the experience of having invested in a return that it unlikely to pay dividends.
In the context of property, a dividend is a bonus, something that wasn’t expected at the time of purchase. For example, an assignment of the lease to a tenant having a better quality covenant could result in a higher value being attributed to the landlord’s interest in the property; a variation to the lease might result in a capital payment and/or higher rent; the location improves and becomes a sought-after location; a change in the law could result in a windfall.
Because property has a reputation as a long-term hedge against inflation, it is suggested that gradually property has a habit of adjusting to its owner’s mistakes. For whatever reason a buyer over-pays, the risk of holding for the long-term is that the property’s definition of long-term could exceed the stage at which the investor’s patience runs out. For patience and the property’s definition to remain in sync, it is to the market that one must look for guidance: there is no point in trying to dump emotional distraught onto the market by for example giving the market six months to provide a new tenant. It’s not the market’s fault that the investor’s choice of proposition was not judicious.
The property market is a dynamic market: it is also cyclical, and while the different sectors of the market each have their own cycles, the weight of money currently available for investment in property is so heavy that the force of the emotion, the desire to invest, is steamrolling over valuation fundamentals into the realm of over-paying.
The Rent Review Specialist