Commercial property has a reputation as a long-term hedge against inflation; a reputation that most investors take for granted. But not all property performs and increasingly more isn’t. A reflection partly of yield-compressed prices to begin with; also whether there is any real capital gain depends upon how strict you are at allowing for non-recoverable ownership costs including debt management, loss of interest on equity, and tax were you to sell.
Underpinning the historic stability of the commercial property market is a space-requirement desire by business tenants to physically occupy and use real estate on a widespread scale. The assumption that that desire is likely to continue indefinitely, combined with the adage ‘buy land they don’t make it any more ‘ leads investors to think that commercial property is a stable store of value.
For all its attractions, commercial property investment is susceptible to groupthink. A psychological manifestation where desire for conformity and place in the socioeconomic hierarchy results in irrational decision-making. A preference for reaching a consensus without critical evaluation of alternative viewpoints, by suppressing dissenting viewpoints, and isolation from outside influences.
Previously, for property performance, capital and rental growth prospects could be identified relatively easily. Nowadays the most valuable real estate is not necessarily a physical asset in the built environment, but a £25 domain name on a computer screen. Forward-thinking tenants are opting out of the tangible property system and transacting on-line, sometimes based off-shore. Many suppliers and manufacturers, particularly in the retail sector, are improving profit margins by cutting out the middle-man wholesaler and retailer and selling direct (by mail order) to the end-customer. Labelling and packaging regulations, with contact details for the supplier, see to that. On-line shopping is a given: the British are prone to putting cheap above quality in the quest for goods and services. No retailer is going to last long if merely regarded by savvy customers as a showroom for the display and touch of goods. Retailers that have transactional websites as well as bricks-and-mortar shops have introduced click-and-collect, but how best to deliver the item to the customer doesn’t solve the problem of customers only buying on-line to begin with and/or collecting their purchase but not when visiting the shop buying anything else. Coming to terms with the shift in consumer behaviour, local traders are shutting shop and multiple retailers pruning branches.
In the office and industrial market, the principles are similar. All businesses have customers and where the customer can be served without the business needing to incur expenditure on property any more than technology requires, the desire for space for the sake of it will lessen.
For tenants, reduction in demand for physical space rarely goes straight to the bottom-line. Operational issues, including how to attract profitable custom, are capital intensive and high risk. For many tenants, the only way they could afford to lease premises is by using cash-flow and debt. Where the money comes from to enable tenants to pay rent and outgoings is not something with which landlords generally are concerned. With a new letting, provided the references stack up and a rent-deposit and/or guarantor provided, the only time landlords hear about issues is when the tenant is late in paying or at rent review when the property system and affordability part company. Paying rent on time is not a reliable indication of profitability of the tenant’s business: honourable tenants keeping the landlord at bay does not mean that the space requirement cannot be dispensed with.
For landlords, tenant reduction in demand for physical space does go straight to the bottom-line. For rental growth, the main driver used be shortage of premises. Nowadays, it is the shortage of suitable premises. For landlords whose property is not on a wanted list, the investment future is bleak, possibly terminal. For property let on a long lease, the likelihood of rent increase at review becomes harder if not impossible to achieve. Where the end of the contractual term is nigh, and the tenant wants to renew, there is likelihood of a rental decrease and/or rent-free period. Where vacant possession is imminent, empty property rates, hefty building insurance premium, and an unoccupied structurally deteriorating building, will hit the landlord’s purse.
The reality of an ex-growth built environment is resulting in a growing sense amongst lenders that loan-security is overly dependent upon the banks themselves continuing to lend on ex-growth property. Currently, revaluations for loan-to-value covenant are propped up by short-term thinking based on auction market sentiment. However, there is anecdotal evidence that lenders are scrutinising the loan book, with loans being called in or injections of more equity required.
It is too early to state what effect if any ‘Brexit’ would have on the commercial property investment market, but one thing is certain: what is happening behind-the-scenes already is emerging and becoming more noticeable.
The Rent Review Specialist