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Commercial property: What can we expect from this asset class?

Ready for a bun fight? Commercial property is a controversial asset class [1], even among passive investors.

Okay, we’re not talking the “Let’s take this outside!” fury of the gold bugs, or the evangelism of a Bitcoin absolutist.

But it’s surprising how much controversy an out-of-town office park with easy access to the M4 can inspire.

Who’s right? Let’s consider the pros and cons of commercial property and you can make up your own mind.

Characteristics of commercial property as an asset class

Academics place commercial property somewhere between shares and fixed income in terms of risk and return [3].

This makes sense if we think about the bricks and mortar reality of property.

While the specifics vary, a commercial property – an office, hotel, warehouse, or apartment block – is basically a building that is let to tenants. Out of these rents, the building usually pays its owner an income. This cash flow is roughly akin to the coupon you get with fixed interest such as a bond.

Think more a riskier corporate or high-yield bond than a government bond, though. The rent from a property is not guaranteed, and the future value of the property is not certain.

The sort of tenants you have may determine how confident you can be as a property owner that they’re going to pay you on time. You may even agree a lower rent with a higher quality tenant. Government bodies or blue chip firms on long leases are safer. Properties let to them are akin to better quality bonds.

Alternatively, you might gamble on risky tenants for a higher income. If they do default you can replace them, after some disruption – unless your property is in a worsening part of town or there’s some other reason why it’s become less desirable, such as rising crime or even a war (possible on a global view.)

Here your property looks more like a very high-yielding, riskier, corporate bond.

We should consider, too, the upkeep of property.

Buildings don’t repair themselves. If you own your own home, you already know property can be a money sink. It’s not just the maintenance and repair. There’s also the cost of keeping up with technological advances and fashion.

Walk around the oldest part of your town. There are no outdoor toilets. Central heating and mains plumping will be universal, even in 200-year old buildings, as will be insulation and glazing, lifts and escalators, communications cabling, and so on.

All those upgrades took money. Keeping your property modern and competitive is an ongoing business.

This is the more business-minded, equity-like aspect to property. Landlords spend to maintain or increase their properties’ value. Such outgoings are another claim on the cash flows coming from rent. What to best spend money on is a judgement call.

That’s very different to a bond. From the investor’s point of view, a bond just sits there paying out cash until it’s redeemed.1 [4] It is a more straightforward investment.

On the other hand, compared to most equities, a property is a pretty stable asset. Many companies strive to reinvent themselves just to keep their customers. The property sector does change, but the pace is slower.

Property is also a real asset, like shares, gold, and ‘valuable stuff’ like antique chairs.

Real assets can increase in value with inflation, unlike paper assets such as banknotes or most bonds. The latter2 [5] are redeemed at a pre-set face value, which means their spending power will be shrunk by inflation [6].

Boil it all down and you see property is a real asset that is a bit of a bond/share hybrid.

No surprise then that the risk versus return profile sits between shares and bonds.

Note that some listed property companies (including some REITs) do a lot of development work. This involves planning and building properties, and perhaps trying to let them out before selling them on. Where development makes up a significant portion of their business (as opposed to letting out finished buildings) I’d say such REITs should be thought of as even more like equities than bonds in terms of risks, rewards, and volatility.

You always need to look under the hood of any property investment, be it a passive fund or an actively managed trust, to see exactly what you’re getting.

An off-the-shelf property empire

I’ve gone into this granular level of discussing single buildings with leaky roofs and dodgy tenants to explain the fundamentals of the asset class.

Fear not – as private investors we won’t be haggling over factories or running office blocks ourselves.

Instead we pool our money into funds. This way we can own a bit of many buildings or developments.

Diversification across an asset class [7] like this reduces the risks compared to buying your own entry-level commercial property, such as a newsagent or a commercial lock-up.

Property funds enable you to get exposure to the underlying asset class with a single purchase. Many pay out a fairly high income, too, reflecting the income-generating nature of most non-speculative3 [8] property investment.

But funds come with their own difficulties, too. We’ll get into them in a follow-up post.

Returns from commercial property

So far I’ve described commercial property through my lens as an active investor.

I just can’t help thinking about how underlying businesses work!

But if I were my sensible passive investing co-blogger, I’d focus on property’s historical returns. There’d be nary a mention of leaky roofs or unreliable tenants.

You say, toe-may-toe, I say, tom-ah-toe – let’s do it his way before he calls the whole thing off.

The Financial Conduct Authority (FCA) recently published [9] historical nominal4 [10] returns for commercial property from 1990.

It also gave the return expectations that it was comfortable with pension funds and advisors using in their forecasts.

Quoting data from the Investment Property Databank, the FCA says:

These returns are at the property ownership level – that is, as if you owned the building yourself. They exclude the impact of development costs and transactions.

Now, huge pension funds and life insurers do own some property directly, as well as using funds.

But private investors like us will struggle to scrape together the money for a tower block in Docklands. We’re interested in the return from the property funds, ETFs, and listed company shares that we use to gain exposure. And you can be sure we will have to pay some costs.

To get closer to this, the FCA looks to the historical returns of the AREF/IPD UK Property Fund Index.5 [11] The index includes:

“… the impact of development costs and transactions as well as the returns from other assets (such as cash and indirect property investments), the impact of leverage, fund-level management fees and other non-property outgoings.”

Costs reduce the return seen by private investors. On this basis, over that same 2001-2016 timescale, the AREF/IDP index has:

Interestingly, the AREF data also goes further back, to 1990. Over this longer time period, which will dilute the impact of the financial crisis:

These returns came with huge volatility, especially during the financial crisis.

Look at the following graph:


(Click to enlarge)

Source: FCA/AREF/Datastream

If you owned property in 2007 to soften the impact of equity market falls, you might have asked for your money back.

An aside about income

That graph shows us another important characteristic of commercial property – in many years, income (the red portion of the bar) is a sizeable portion of the return you get from property.

The income component of the return is also far more stable than the feast and famine of capital gains.

Be sure to hold your property assets in a tax shelter such as an ISA or SIPP where possible, to avoid this income being scythed away by taxes.

Also note, the income paid out by a REIT looks like a dividend but most of it is technically a Property Income Distribution.6 [13]

This may present tax issues outside of tax shelters. See this handy explainer [14] from British Land.

The REIT stuff

As we’ll see next time, many private investors get their property exposure by investing in a particular kind of investment trust called a REIT.7 [15]

The FCA gives nominal returns for the FTSE 350 index of these REITs as follows:


Source: FCA / Bloomberg

Total returns since 2005 look lousy – especially given the accompanying high volatility. (A downside of stock market-listed property funds is you get at least some of the volatility of shares but also the lower expected returns of property.)

It’s clear the financial crisis of 2007-2009 clobbered returns, as we also saw in the graph.

Over the shorter period since 2010, returns have been good. But half a dozen good years is a thin track record to hang your hat on, even if you believe the financial crisis was a once-a-generation event.

Some property skeptics such as Lars Kroijer [17] argue that we simply don’t have enough long run data to justify investing in this asset class specifically8 [18] – at least not as private investors.

To that point, the specific REIT structure has only been going in the UK for a little over a decade! (Previously what became the first REITs were more traditional property companies with a less attractive tax profile.)

You may retort that individuals have made famous fortunes wheeling and dealing in property directly. But this experience may not prove to be very analogous to owning a stock market-listed REIT in an ISA.

On the other hand, Tim Hale of Smarter Investing [19] fame believes the (short-run) data is good enough to justify adding a global REIT to a passive portfolio.

After voicing reservations about traditional property funds that locked up investor money during the financial crisis9 [20], Hale says:

Holding a global REIT passive fund makes sense from a diversification perspective […]

Property tends to have a low correlation to equities, providing diversification benefit, as property performance is usually linked to rental value, in turn linked to economic growth, unlike the earnings of non-property companies that are less correlated to economic growth.

This is borne out in a correlation of 0.5 that is exhibited between UK equities and global property. This diversification is achieved without the substantial return give-up of holding bonds or cash.”

While I broadly agree, I’d caution that Hale’s correlation data does not seem hugely extensive. It’s unclear from his book, but as best I can tell it seems to be drawn from the 20-year period from the 1990 to around 2009.

Also, given that interest rates mostly fell throughout those years – eventually to near zero – I wouldn’t describe it as a wide range of environments to draw conclusions from.

I’m also unclear as to whether Hale has backed out currency swings when he compares a global REIT to UK equities.

Again, over such a short time frame, currency risk could be a meaningful contribution to relative returns.

Future returns from commercial property

Summing up, property valuations can be almost as volatile as equities, but the income is generally much more stable, giving us a mix of the characteristics of equities and bonds.

In addition, property itself tends to be illiquid, due to the expense of buying and selling.

This may or may not be the case for your chosen investment in the short-term10 [21] but it stands to reason that long-term, property holders will probably get an additional return for putting up with this illiquidity with their risk capital.

What’s it all worth, in terms of expected returns? Finger in the air – probably a bit more than owning very liquid bonds, but a bit less than owning very volatile equities.

The FCA report agrees, and estimates an expected real return on property that’s somewhere between the expected returns from equities and from bonds:

We assume a spread over government bonds of 3% to 4%, over a 10-15 year time period.

This implies a real return on property of 2.5% to 3.5%, based on the midpoint of real government bond returns of -0.5% and nominal returns of 5% to 6% based on a GDP deflator assumption of 2.5%.

This expected return guidance from the FCA is lower than it recommended just a few years ago in 2012, incidentally.

The reduction follows a corresponding drop in its projected real returns from government bonds. As I’ve mentioned many times, you can’t just look at rock bottom government bond yields and presume everything else is that much more attractive – at least not if you believe in classical economy theory.

Government bond yields underpin expectations elsewhere; they are the ‘gravity’ of financial markets, as Warren Buffett puts it.

If forward returns from government bonds are low, then the market has its reasons (it fears recession, or doubts we’ll see inflation, for example). Those reasons will often affect what we can expect to see from other asset classes, too.

On the other hand, while expected returns are a key part of passive portfolio construction, I wouldn’t bet my life on them. Forecasting is fraught with difficulty.

Property, especially, seems to me an asset class in limbo. It’s been struck by a deep crisis within the past decade while also being boosted afterwards by ultra-cheap money.

In addition, the world’s property estates face a secular upheaval from the shift to online shopping, socializing, and business, which could permanently impair the demand for some property, or at least force more refurbishment and regeneration.

Don’t get me wrong, I think the asset class has its attractions – and UK REITs focused on London seem to me [22] a potential bargain right now. But I’d suggest a modest allocation of about 5-10% is about right for most passive and active investors, given the risks, prices, and economic backdrop.

In a follow up article I’ll look at how you can buy into property without dealing with a single suited geezer or donning a hard hat. Subscribe [23] to make sure you get it!

  1. A professional bond investor will look into the viability of the company or government behind the bond. But the actual security itself is just an IOU with a known income attached. [ [26]]
  2. That is, not inflation-linked bonds [ [27]]
  3. i.e. Development. [ [28]]
  4. That is, without adjusting for inflation. [ [29]]
  5. This is based on the performance of members of the UK Association of Real Estate Funds (AREF) and published by IDP. [ [30]]
  6. In short, the letting income is paid out as a PID, whereas money made from other activities can be paid out as a dividend. [ [31]]
  7. Real Estate Investment Trust. [ [32]]
  8. Global index funds as favoured by Lars will include a small percentage of property companies. [ [33]]
  9. Some also did this again after the Brexit vote correction. [ [34]]
  10. A REIT can be sold at any time, but potentially at a discount to underlying value, a non-listed fund may be ‘gated’, locking up your capital, which stops panic selling but is no good if you need the money. [ [35]]