Scotland’s commercial property market continues to be buoyed by a healthy supply of investors keen to pump money into property. These investors comprise not only financial institutions and fund managers but also overseas and individual property investors. Many are entrepreneurs that have taken control of their own affairs by investing directly in property themselves due to dissatisfaction with the returns from their pension funds.
It has been this steady supply of money into the property market from investors, rather than rental growth, which has kept property values at record levels.

From early 2005 through to this summer, a noticeable feature of the Scottish commercial property market has been a tightening of the traditional yield gap between primary and secondary properties.

However, with interest rates having crept up recently and looking likely to creep up further, coupled with a lack of rental growth, valuers and lenders have realised, albeit belatedly, that primary and secondary yields have simply been too close over recent months. As a consequence, the market is currently adjusting to re-establish the traditional gap between primary and secondary property yields.

Whilst prime yields have, if anything, grown firmer over recent months - a reflection of the fact that good quality stock will always be in demand from Institutions - there are some secondary properties that have failed to sell or whose yields have fallen as valuers, banks and investors have realised that secondary and tertiary properties have been over-valued.

Indeed, through 2005 yields from a primary retail property such as Glasgow’s Buchanan Street were broadly equivalent to those from a secondary retail property in the city’s Byres Road. Of course, the relative prospects for rental growth in each of these locations is open to debate since property valuation is an art rather than a science, so some investors might regard the prospects for rental growth in a secondary property in Byres Road to be greater than those for a prime city centre property in Buchanan Street.

These market trends have required some lateral thinking on the part of investors and particularly property companies. For example, rather than acquiring properties with a view to adding value to them and increasing the rent through hands-on asset management, some investors, particularly property companies, have instead moved into Europe, returned to development or looked at other classes of investment, such as leisure and healthcare.

This is a sensible strategy in times when yields are so low. Most investors seek to maximise returns by high gearing on their properties, however this high loan to value strategy results in no surplus income on rents received, that is, investors either deficit finance the project or input more equity.

Bearing in mind the high trading costs, comprising 4% stamp duty, solicitors and surveyors fees, it is perhaps small wonder that property companies found it hard to justify the risk of committing fully to investment trading over the last 18 months. With the benefit of hindsight, of course, that risk proved to be justified because yields have since improved. Indeed, those investors with the courage of their conviction to buy property in spring 2005, might well have found themselves, courtesy of improved yields, in the enviable position of selling the same property in spring 2006, not having required to spend any significant sums of money on it, and reap a healthy reward.

Furthermore, some investors have explored successfully more marginal locations, such as county towns like Alloa and Dingwall. One of the largest sectors of property transactions over the last few years, and another channel for investors to exploit opportunities, has come from owner/occupiers selling their property assets and returning that capital into their core business and that’s a trend that looks likely to continue since the highest percentage of commercial and industrial property in the UK remains owned by owner/occupiers.

The government realised the benefits to be had from outsourcing property ownership years ago, introducing the PFI and PPP programmes to build new schools and hospitals, and the same principle of property sale and leaseback still has a major role to play in helping owner/occupiers maximise the potential to be had from their core business.

Yet whilst there has been, and continues to be, a degree of adjustment in the market to reassert the true distent between primary and secondary property yields, a noticeable feature of the market in Scotland is that yields tend to be firmer than those south of the border as, in general, the Scottish property market is less volatile than it is in England.

And it is this stability that appeals to many foreign property investors, particularly Irish investors well used to lower yields from their native market. The fact that Scotland’s occupational property market tends not to experience the same peaks and troughs as that south of the border, particularly the south east, attracts foreign investors. Nevertheless, the occupational market, particularly in the retail sector, which is mature and saturated, is weak, and since occupational demand drives rental growth, some investors are beginning to be more cautious.

Looking ahead, Real Estate Investment Trusts, or Reits, look likely to have a significant impact on the market when they come into effect in January 2007. Introduced by the government with the aim of improving the efficiency of both the commercial and residential property investment markets, not only should Reits provide the basis for liquid and publicly available property investment vehicles available to a wide range of investors, they should also encourage increased Institutional and professional investment to support the private rented sector.

The regime, which will be open to companies resident in the UK that are publicly listed on a recognised Stock Exchange, will provide a separation for tax purposes of the ownership of property from the activities that take place on that property by establishing a ring-fence around the qualifying property letting business of the Reit.

They will also provide the flexibility necessary for companies to undertake other activity within the non ring-fenced business, which would include income generated from ancillary services associated with the property letting business and development undertaken with the purpose of generating a trading profit. The legislation requires that the majority (at least 75%) of the Reit’s activity relates to the ring-fenced business by reference to both its total income and assets.

Companies that meet the Reit eligibility criteria will not pay corporation tax on qualifying property rental income or qualifying chargeable gains that relate to the ring-fenced business, though a Reit will be required to distribute at least 95% of its net taxable ring-fenced profits to investors who will then pay tax at their marginal rate. Further, the Reit will be required to withhold basic rate tax on the distribution paid to investors on behalf of HM Revenue and Customs.

Shares in Reits will be eligible to be held in an Individual Savings Account, Personal Equity Plan or Child Trust Fund subject to the existing limits and rules. This should allow the successful growth of the market, whilst promoting the government’s objectives for a liquid and publicly available investment vehicle and preserving fairness for all taxpayers by offering the necessary protection for the UK Exchequer.

As Reits are likely to be a considerable factor in 2007 and have a lasting impact on the commercial property market, investors would be well advised to familiarise themselves with the regime. Or, to put it another way, it might be time for property investors to consider doing the Reit thing.

Colin Whitelaw is Chief Executive of Property Investor Partnerships

ENDS