Investment in Real estate
Property investment involves the acquisition of tangible assets which comprise of land and buildings (Investment Property Forum, 2015). The value of the buildings decreases or becomes obsolete or declines due to wear and tear. However, the value of land tends to increase over time particularly in the United Kingdom where the supply of land in limited. The value of a property can increases in value through continued investment and active management. This can be achieved through refurbishment and redevelopment. The ownership of property often has management and ownership cost. The amount of these costs depends on the type of lease agreements. Usually, in the United Kingdom, the landlords require the tenants to bear the cost of repair, maintain and insurance of the buildings. For some investors, it is often easier to buy stocks and bonds which require no active management from the investor except for the decision to buy or sell.
Features of Property as an Asset Class
One of the key features of the property as an investment is that it is heterogeneous (Investment property forum, 2016). This is because property often lends itself to a large range of uses. This allows for diversification of the property irrespective of its size. The heterogeneous nature of property has some disadvantages. The ability to modify a property makes it difficult to value at future dates. The value of property, particularly after modifications have been made, can only be estimated by a professional surveyor. This makes the property a very illiquid asset that is often costly and timely to dispose of.
The lack of a central trading exchange is a feature of property investment. There is no single market or exchange through which the property can be bought and sold directly. The buyers and the sellers are often forced to transact through intermediaries. Another characteristic of property as an asset is lot size. The unit cost of individual property and pieces of land is very high as compared to that of other investments. Property investments such as shopping malls, office buildings in key cities are often too expensive for the individual investor. Typically, these properties can only be acquired by institutional investors, property funds, property companies, and real estate investment trusts.
Size and Structure of the Property Investment Market in the United Kingdom
The property market in the UK is estimated to be £ 5,480 billion with the residential segment accounting for over 65 percent with a value of over £4,670bn. Commercial property accounts for approximately 12.5 percent with a value of £683 billion. The remaining segment of the market is constituted by private home ownership with a value of £127 billion (Investment Property Forum, 2015). The value of the property market in the UK is greater than the value of the London Stock Exchange and the Gilt market combined.
Factors that Drive the Property Market in the United Kingdom
In the long-run, the property market in the UK is determined by two factors namely interest rates and employment (Thorpe, 2016). The interest rates drive that value of assets like property because they determine whether borrowers can access finances. To acquire properties particularly commercial property majority of buyers have to use debt to finance the acquisitions. The rate of interest in the United Kingdom has been low and declining over the last few years. This has created good conditions for the acquisition of real estate. The low-interest rates have also driven investors into the property market because the returns are higher than from interest rate-based securities.
The level of employment determines the performance of the property market as it determines the value of rents and the demand for leases. The spending by consumers in retail outlets determines the demand for commercial properties and other retail property. Spending by consumers is determined by the level of employment and wages. The level and growth of employment and wages are often used as proxies for the level and growth of rental incomes in the long run (Thrope, 2016).
Getting Property Investment Right
Property investment is all about timing and choosing the right sector. The property can offer a variety of risk and return profiles. When the right conditions are achieved, the returns to the investors are high; when the conditions are wrong, the investor suffers losses. The choice of property investment strategy is determined by the risk appetite of the investors. The main risk associated with property include
- Asset Specific Risk: Particular segments of the market are affected by risks that are specific to that segment. This is particularly important to investors who hold only one type of property. For example, the return on investment in hotels and other tourism-related property will be affected by security risks such as the threats of terrorism.
- Sector and Geographical specific risk: Owning property in a specific sector or geographic location could result in good performance or poor performance. House prices in areas in and around London have increased by 11.9 percent during the fiscal year 2015-2016. This performance is in contrast to that in Scotland where house prices have reduced by -0.5 percent during the same period (Global Property Guide, 2016). Buying property in Scotland has a high risk of yielding negative returns.
- Political Specific Risk: Currently, the property market in the United Kingdom is dealing with the consequence of the Brexit vote. Given that the full consequence of the vote has not been fully realised some investors with less appetite for risk and uncertainty are moving out of the property market. The political environment will determine the returns realised by property investors.
- Macroeconomic risks: Macroeconomic factors like economic growth, growth in employment, interest rates, and taxation determine the return on property investment. The investors have to take them into consideration when they develop buy and sell strategies. The three percent increase in the stamp duty charged in the United Kingdom is likely to affect the property market in the UK negatively (Global Property Guide, 2016). For example, a property owner who has a property worth £ 1,000,000 and hopes to make redesign the property, to make five apartments, would incur a stamp duty of £ 73,750. This cost does not include other transaction costs.
International Property Measurement Standards
The International Property Measurement Standards (IPMS) were developed by the International Property Measurement Standards Coalition (IPMSC). The IPMSC is a collaboration of seventy-three independent professional associations that have a presence across the globe (RICS, 2016). The aim of the coalition is to harmonise the individual national property measurement standards through the development and adoption of agreed international standards that can be used for the measurement of buildings. This collaboration will bring about efficiency and greater confidence in the property and real estate markets as the investors and renters are assured of consistent in the process of property development.
The use of IPMS has gained popularity with organisations like the International Monetary Fund, international property companies, corporate occupiers, and government indicating that it is mandatory for property developers and owners to ensure that their properties adhere to the standards. The current IPMS cover office buildings, residential properties, industrial complexes, and retail properties (n.d.) The IPMSC is currently working to expand the list of properties covered by the measures to include facilities like schools, universities, hospitals, hotels, restaurants, and hostels
Full Repairing Lease
These types of leases are often referred to as full repairing and insurance lease (FRI). Under this agreement, the tenant is responsible for full repairs and insurance of the premises that he/she has let. Essentially, the owner of the property is relieved of the costs of repairs and insurance (The Caesar and Howie Group, 2016). These types of leases are commonly used for commercial properties with the aiming being to ensure that the landlord reduces costs by passing them on to the tenant.
Prior to signing the lease agreement, the tenant has to ensure that the premise meets the ideal standards. To ascertain the condition of the property, the services of a building surveyor are often obtained. In situations where the standards are not met, the tenant can require the landlord to make repairs before the premise is occupied, carve out from the FRI agreement the items that are not in good order, or annexe the lease terms and conditions to highlight the areas that do not meet the standards. The tenants can also insert a clause that limits their obligations by providing for fair wear and tear (The Caesor and Howie Group, 2016).
The landlord normally prefers to insure the premise and require the tenant to repay the premiums. This is to ensure that adequate and appropriate insurance cover is taken and to ensure that the premise is insured at all times. In situations where the landlord takes up an insufficient insurance cover, the tenant can hold the landlord liable for damages not covered. However, this action by the tenant might be limited if the RFI agreement is terminated when the property is damaged or destroyed. In situations where the tenant continues to occupy a building when damages are being repaired, they are entitled to reduced rent rates (The Caesor and Howie Group, 2016).
Upward Only Rent Review
The term upward only rent review is a provision made in the lease agreement that facilitates the passing rent, that is stated in the current lease, to be adjusted to current market rent rates. The adjustment of the rate must be greater than the rate passing immediately before the rent review date or the current market rent (McHugh, 2015). This provision ensures that the passing rent under the tenant’s current lease cannot reduce to less than the current rate. A key shortfall of this provision is that in some situations, the tenant pays more than the market rents. Further, the provision that the rent moves upwards, often disadvantages tenants, particularly in times of recession. The landlord imposes upward only rent review clauses in the leases to protect their income from negative economic conditions.
In 2009, following the recession in Ireland, Section 132 of the Land and Conveyance Law Reform Act was enacted. This law banned upward only rent reviews until February 2010 (Mathews, 2015). This legislation aimed to protect tenants with current leases. This is because during the period 2004 – 2009 the retail rents had fallen by 63 percent, business premises rent by 59 percent, and industrial rents by 68 percent.
Rent Free Periods
To attract tenants, the owners of properties sometimes offer incentives. For example, the tenant can sometimes be given cash awards when they sign the lease, or they may be allowed to occupy the premises for several months before they start paying rent. The latter provision is often referred to as rent free period (Bartletts Solicitors, 2015). Typically, rent free periods are given at the beginning of the lease, but at times they may be given during the lease period.
Estimate of Expected Selling Price
In the United Kingdom between August 2013 and August 2014, the price of property increased by 3 percent (UK Government, 2016). Therefore, the price of the building in August 2014 would have been £ 41,200,000 (£40,000,000 x 1.03). Between August 2014 and August 2015, the price of properties reduced by 3 percent (UK Government, 2016). Thus, the price of the building in August 2015 would have been £ 39, 964,000 (£ 41,200,000 x 0.97). Between August 2015 and August 2016, the price of property in the United Kingdom increased by 3 percent. Thus, the price of the building in August 2016 was £ 41,162,920 (£ 39,964,000x 1.03). Given the current market trends, it is expected that the sale price of the building would be £ 41,162,920.
Annual Rental Income is £900 per square meter x 2,000 square meters = £ 1,800,000
Total Rental Income = £1,800, 000 x 2 = £ 3,600,000 (two years are taken because one year was rent free).
Total Return = £41,162, 920 -£ 40,000,000 + £ 3,600,000 = £ 4,762,920
Return on Investment = £4,762,920 / £40,000,000= 0.12 = 12%
Average annual growth over the three years is 4%
The leasehold interest is 2.9 percent (£ 1,162,920 / £ 40,000,000). The leasehold interest is estimated on capital value approach given that the lease is for a long period of time.
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