By Adrian Gaspar
Many institutional investors are familiar with commercial property as a source of competitive risk-adjusted returns with low correlations to other major asset classes like gilts and equities. Independent research from companies like the British Property Federation, IPD and Acadametrics suggests residential property also offers robust risk and return characteristics from a similarly uncorrelated asset class, but are they the same?
In short no, there are numerous differences that need to be considered. The valuation of a portfolio of private rented residential properties will be based on capital values, typically at a discount to vacant possession value if there are sitting tenants. When valuing residential property a surveyor will have access to Land Registry data on recent transactions for similar properties in the same locations. The value of a commercial property is driven by a capitalisation of the rental income it generates.
Residential property is generally let under Assured Shorthold Tenancy Agreements (ASTs) with the responsibility for maintenance of the property falling to the landlords, who thus have to pay on-going maintenance and management costs out of income received. The minimum term under ASTs is six months after which the landlord can regain possession of the property having given the tenant two months’ notice.
Commercial property is normally let on a Fully Repaired and Insured (FRI) basis with the tenant responsible for on-going repairs and maintenance and is usually subject to longer term leases (typically five-10 years) than in the residential sector although many leases will have breakpoints at certain anniversaries and rent reviews, which are generally on an upward only basis. The longer term nature of commercial tenancies can provide relatively secure and steady cash flow however as the structure of buildings age and occupiers’ preferences change commercial properties become obsolescing assets.
These differences in valuation and tenancy arrangements also explain why the net yields from commercial property will often be higher than from residential and also why investors would rightly expect a greater element of capital appreciation from a portfolio of residential property. Residential and commercial properties are both physical assets and hence less liquid than assets traded on exchanges. Residential property offers better liquidity due to the difference in size of the market, lot sizes and volumes of sales. The shorter term, and rolling, nature of ASTs also gives a residential property fund manager more flexibility should they need to realise assets.
The costs associated with buying physical assets like property can be higher than other assets, although the disaggregation of stamp duty land tax (SDLT) on bulk purchases of residential property means large scale investors pay tax on the mean, rather than the aggregate value of purchases. In effect a residential property fund could buy several million pounds worth of property but only pay 1% SDLT, whereas a commercial property fund manager would likely pay 4% on most purchases.
Whilst the dynamics and characteristics of the two are quite different the performance characteristics are similar and there is a fairly strong positive correlation of returns. Historically, commercial property values have tended to react more quickly to negative changes to the economic environment and research suggests that residential property is less volatile than commercial but of course is not immune to the effects of challenging economic conditions, with house prices in many regions below the peaks of 2007.
In summary, professionally selected and managed portfolios of commercial and residential property both offer diversification for multi asset investors with varying levels of potential capital growth and yields. The different return profiles coupled with the technical differences between the two would suggest that it is not really a case of residential or commercial when looking to allocate to property but it is more residential and commercial.
Adrian Gaspar is technical sales manager at Hearthstone Investments
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