This article is kindly contributed by Peter Ogden, KBW Chartered Surveyors. Peter’s contact details are at the end of the article.
If you have decided to invest in property (real estate) here are some points to consider in assessing opportunities. We will be looking here at direct investment in property rather than via funds, equities and other similar financial instruments.
There are two principal ways to earn money from Property investment, these being rental income from tenants and capital growth from increases in the value of the property. A significant factor in your investment decision will be your risk appetite. High returns are associated with higher risk and in property this will usually mean a less secure income stream (rental income). On the other hand lower returns will be associated with longer and more secure income streams. Decide on your risk appetite, look at the level of return you are expecting and assess the opportunity in light of your risk position. Good quality property investments will return around the 4%-5% mark whereas the higher yielding (higher risk) property 10%-12% plus. Remember to build in capital growth as some investments show a low rental return but have the prospect of higher capital growth.
Opportunities to add value
Any assessment of an investment opportunity should include reviewing what opportunities exist for adding value. Some properties which come to market may not have been pro-actively managed and present such opportunities. Look for vacancies that may be filled or created, replacing weaker tenants when opportunities arise and implementing rent increases as soon as these are available. There may be opportunities for re-structuring or extending existing tenancies to enhance value. Conversely, leases near the end of their term may detract from the quality of the investment especially where the chances of finding a new or similar strength tenant is low. Get a view by talking to tenants to see what their plans are.
There may be opportunities to cut cost and increase net returns by reviewing service provider contracts. Be careful of what appears to be low landlords’ costs as there may be hidden costs.
The current use of the property may not be optimised so a change of use, space reconfiguration or property development has potential to add value although it may be difficult to develop listed buildings and buildings in conservation areas. Local letting agents and commercial property agents will be able to give a view on management, reconfiguration and development opportunities. The local planning authority will be able to give a view on change of use, development, listed buildings and conservation areas.
Trends affecting the location
Watch out for potential changes in the character of a location. Check with the local planning authority especially their Local Development Framework plan and ask about any planned changes. Check local press, the web, and local knowledge about what’s happening in the locality. Changes can be positive or negative for example a new out of town retail park may have a detrimental effect on a local established high street or a road improvement scheme may improve access and have a positive effect on local property. Adjoining developments or others close by may impact on an existing property.
The return on your investment and thus its value will largely be dependent on rental income. For residential investment this will be from domestic tenants and for commercial property, business tenants. Which tenant sector and industries you choose will depend upon your view of the wider economy and where this is going. There are many debates raging at present. There is clearly a deficit of residential space especially in the South East and internet shopping is changing the face of retail in many towns. Collaborative working, flexible and home working is impacting on the demand for office space and the perceived need to develop our manufacturing industries may change demand for industrial space. Many local pubs are closing in favour of multiple owned outlets although restaurants and coffee shops are in fashion. Your view of the economy will impact choice of investment property and form an important part of the assessment of opportunities.
You’ve heard many times property is about location, location, location and this is no less true for property investment. Consider the economic position of the area, city or town. Does it have a buoyant economy and is this likely to be sustained or grow in which case the outlook for landlords will be good? A depressed economy may have prospects for growth which could be a positive factor. A static or declining local economy may have a negative effect on property values or maybe the bubble has or is about to burst? The property you are considering may have good tenants but it will be important to consider the likelihood of finding new tenants if or when the existing ones leave. Also are the existing tenants compatible with the locality or the future of the locality if there is a likelihood of change. Local estate agents and commercial property agents will be able to give a view.
An important consideration will be the trend in market rents for the locality. The current or ‘passing’ rent may have been set some time ago and the market rent may have changed so that when a property or unit becomes available the new rent may be different and the income stream may change. This could be positive or negative and local agents will be able to provide information on current market levels.
Direct investment in property is usually for the long term. Property is an illiquid asset and acquisition costs can be relatively high. Stamp Duty Land Tax (SDLT) will be the main cost at 4% for properties over £500,000 and there will be other costs e.g. legal, surveyors. Watch out for the buyer’s premium if you are buying at auction and VAT may be payable on a commercial property depending upon its VAT election status.
Your income stream will be from rents but there may be costs which reduce net returns. The responsibilities for repairs and maintenance vary depending on the type of property; in commercial properties tenants are typically responsible for these costs or a share of these costs in multi-tenanted buildings, while in residential properties landlords are typically responsible. Residential landlords will need to budget for the costs of buildings insurance, maintenance costs, ground rent and other incidental charges. Residential property is also likely to require more management time (and/or cost) than commercial property. This is because of smaller unit sizes, shorter lease lengths, and a greater obligation for maintenance and repairs. In both residential and commercial properties there will be the cost of re-letting when the property or unit becomes vacant.
Vacancy costs also need to be considered. You will need to allow for voids of income when the property is empty. The landlord may also be responsible for paying council tax or business rates when a property or unit is empty. The property will still need to be maintained and insured whilst empty and in commercial property the landlord will have to pick up the bill where tenants would normally. Insurance premiums may rise to reflect the increased risk of vandalism and damage. Insurers may require additional measures such as draining down water systems, isolation of electrical supplies and more frequent inspections of vacant properties or parts.
Covenant strength of tenants
The continuity of the income stream will be dependent on the strength of the tenant and their ability to continue to pay rent. Tenancies may end by the natural expiry of a lease or the income stream may be interrupted if a tenant ceases to be able to pay the rent. Whilst there is a contractual obligation on the tenant to pay rent, tenants may become insolvent or bankrupt and landlords are usually unsecured creditors. The stability and financial strength of tenants is paramount in assessing the quality of the investment.
There are a number of ways of assessing the strength of a tenant, referred to as ‘covenant strength’ and the covenant strength of the tenant will have a direct bearing on the yield from the property. Strong covenants will usually produce lower yields (more secure) and vice-versa.
The strength of a residential tenant can be assessed by looking at their income and employment. Clearly, a tenant with stable and long term employment will be a better bet than a one with a short contract or history of frequent job changes. Ask the seller or his agent about the tenants and check the contract (AST) to see if there are any guarantees from someone who will take over rental payments in the event of the tenant defaulting. There are also insurance policies available to cover tenant rent default. Rental deposits are a common way to provide some cover for non-payment of rent or repairs which are necessary when a tenant leaves. Deposits for residential lettings have to be held in a recognised scheme and the scheme administrator will adjudicate on the release of deposits where there is a dispute. You should also understand the likely levels of vacancy by making enquiries of local letting agents.
For commercial tenants there are a number of methods of assessing covenant strength. For established businesses a review of their accounts can provide an insight into their historic and current performance but this must be measured against future outlook for their business. The previous track record of directors is worth evaluating for new or fledgling companies. Specialist agencies such as Dunn and Bradstreet are often able to provide data for a fee. The previous landlord may have obtained references for the tenants so ask to see those which may include bank references and references from previous landlords. Also there may be references from tenant’s own suppliers and other business associates about the promptness of payments which will be a good indicator of their payment record. Common mechanisms where the covenant is weak or unproven include rental deposits, personal guarantees from directors and guarantors. If you are buying an existing investment property check that these guarantees and deposits are transferrable.
It will be important if buying an existing investment property to examine the track record of tenant payments. Ask the existing landlord or his agent for payment profiles for all tenants. What is certain is that recovery of rent arrears can be difficult, time consuming, costly and doesn’t always result in full recovery.
Terms of tenant leases
The structure of the lease or leases is an important consideration in assessment of the quality of the investment. Residential tenants are normally contracted via an Assured Shorthold Tenancy (AST) which is usually 6 or 12 months at the outset then continues on a monthly basis until either the landlord or the tenant gives notice usually one month. The AST will set out in detail to do’s and don’ts for both landlord and tenant.
For residential property there are also a number of statutory provisions to beware of and these include; Right to Manage (RTM) where tenants can elect to take over management of the property if the residential leasehold parts are 75% or more of the total property; Leasehold Enfranchisement where tenants have the right to buy the freehold of their property; Protected tenants, usually historic, who have greater rights than those occupying under an AST and Landlords’ rights to recover costs, even those covered in leases, which is governed by legislation and there is a strict process to be observed to ensure the right to recovery. Residential leasehold law is a notoriously complex subject and your solicitor can advise on these aspects and others that may affect the quality of the investment.
For commercial properties the obligations of landlords and tenants are set out in the lease. Most leases provide for a periodic review of rent and many commercial leases provide that the rent can only rise or remain static depending on market values but not fall even if the market rent falls (‘upward only rent review’). This further protects returns. Some leases provide for fixed rent increases (escalator rent) and some are linked to an index e.g. RPI / CPI. A common method of incentivising tenants at the start of a lease is to grant a rent free period or rent holiday so it is important to check if there are any outstanding incentives or other provisions which may vary the income stream. Another common mechanism in commercial leases is the ‘break clause’ which may give the tenant the option to prematurely end the lease.
Business leases are subject to various pieces of Landlord and Tenant legislation and one important aspect is that business tenants usually have the right, in principle, to renew their lease when it comes to an end. It is not uncommon however for tenants to opt out of this provision at the start of a new lease in what then becomes an ‘excluded lease’. An excluded lease is advantageous for the landlord as it gives more control at the end of a tenancy. Check if leases are included or excluded.
Most commercial leases oblige the tenant to keep the property in good repair and return it in good repair at the end of the lease. Consider how likely is the tenant to keep and leave the property in a good state of repair. Inspect the property to see if the tenant is keeping up with repairs. If you are left with a property in disrepair, disputes can be lengthy and costly.
If the property is multi-let to different tenants then the landlord usually has responsibility for maintenance of the shared areas and common services although tenants will usually contribute by way of service charge. Check that 100% of the service charges are recoverable from tenants or what proportion is not as this will be a cost to the landlord.
There will be many other clauses in leases which set out the respective responsibilities of the landlord and tenant and it is essential to understand these. Take advice from your legal representative to see how these impact upon the investment.
There are a multitude of compliance matters in property investment and an assessment of the state of compliance is essential before committing to a property. The legal process of acquisition will formally deal with this but early enquires may save time and help better understanding of the investment. Any shortcomings in compliance could involve the landlord in costs. The basics of compliance include asbestos surveys, fire risk assessments, fire equipment maintenance records, boiler, ventilation and air conditioning maintenance records and certificates, gas safety tests and certificates, electrical testing and certificates, planning consents, building regulations consents, lift maintenance records and schemes of examination where there is a lift, testing for legionella and waste transfer notes. A good state of compliance will be indicative of a well managed property.
Whilst management of property may appear daunting there are many established property managers and managing agents who are able to deal with financial management, compliance and day to day management of property investments. Managing agents’ fees in commercial property are often recoverable from tenants via the service charge but these fees are usually a landlord’s cost in residential property. The costs of managing the investment will form part of the assessment.
Property managers and managing agents have mixed reputations and it is worth checking with professionally qualified managers and agents as to cost. Property managers or managing agents who are members of the Royal Institution of Chartered Surveyors (RICS) are regulated by this institution and have a scheme to protect clients’ money. Other professional institutions such as the Association of Residential Managing Agents (ARMA) will give some comfort of obtaining a reliable service.
If the property has been professionally managed previously then talk to the managing agent about how the property is managed and their relationship with the tenants. If you are thinking of using the same managing agent then ask the tenants, who will effectively be your customers, if they are happy with the service they receive from the agent. Is the agent alert to your main priority which will be maximising the income stream and does the agent have a pro-active agency team who will give top priority to re-letting your property or unit when it becomes vacant? Does the agent have other team members who can advise on matters which may arise during the life of the tenancy e.g. rent reviews, maintenance and repairs, dilapidations, etc?
The structuring of your holding and tax position in relation to the investment will be important. Consideration should be given as to how you will hold the investment. Options include private investment, limited liability partnership (LLP), private limited company and others. The tax position will vary according to personal circumstance but in simple terms income tax is paid by the investor on the net rental income, and capital gains tax is paid on any gain made when the property is sold. Matters to be considered include personal taxation, tax wrappers e.g. self invested personal pension scheme (SIPPS), corporation tax (CT), capital gains tax (CGT), inheritance tax (IHT) and VAT. Your accountant will be able to advise.
The value of property as an investment class is usually measured against income streams and risk via yield. The value of capital and income will fluctuate as real estate values and rental incomes rise and fall. The role of the professional valuer is therefore important in establishing the value of a property at a point in time. However, it should be remembered that a valuation is not a price, but an estimate based on expert knowledge and the application of consistent rules.
Some investors use borrowing where their own funds are insufficient or to leverage expected capital growth. In outline lenders will take a view on risk and tailor their products by varying the LTV (Loan to Value) ratio and interest rate. Lenders will lend a higher proportion of the value of a property for lower risk investments. LTV ratios are typically between 40% and 70% depending on risk. You may also pay a higher rate of interest reflecting the increased risk for the lender. The lender will also have restrictions on the amount you can borrow depending upon expected rental incomes. This is a specialist area and discussion with a financial advisor will be necessary if you wish to pursue this option. Financial advisors are authorised and regulated by the Financial Conduct Authority.
Like all investments, property is not without risk and you may get back less than you invested or returns may not be as expected.
Peter Ogden, the author, is a consultant at KBW Chartered Surveyors. He can be contacted on 01242 244744 or at email@example.com.