In today’s discussion, we delve into the alarming prospect of a commercial property crash and why it should concern us all. It’s a significant topic, and while some may debate whether such a crisis is imminent, we argue that we are already witnessing the signs of it, primarily due to increased risk factors.
One of our clients serves as a prime example. We acquired a property for £570,000 in late 2021, aiming to fully lease it out and refinance it at a value between £700,000 and £750,000. This would have aligned with the prevailing market yields at the time. Our strategy hinged on securing long-term leases of five to ten years, with some already renewed for a decade. This approach would have allowed us to refinance at an 8% yield, given that we initially purchased the property at a 10% yield, mainly due to two vacant units.
However, our plans took a hit when three lettings on the second floor fell through at the last minute, resulting in a revaluation that matched the purchase price. The reason for this valuation stagnation, despite securing other leases, was the shift in the base interest rate, causing increased risk levels in the commercial property industry. Consequently, we now witness a lower yield on the property, around 9.5%, compared to our initial expectation of 8%.
Furthermore, the landscape is shifting due to the allure of bank accounts offering 6% returns, prompting investors to question the rationale of investing in commercial or residential properties. When the net yield from property barely exceeds that of a bank account after factoring in various expenses, including mortgage payments, maintenance, and management costs, potential investors are inclined to opt for the safer option of a bank account.
This phenomenon can be attributed to several factors. First, property values aren’t appreciating as rapidly as they were at the end of 2021 and the beginning of 2022. We never possessed a crystal ball, and while we anticipated interest rate hikes, the speed at which they occurred caught us off guard. Consequently, yields on commercial properties have risen, albeit they cannot fall below the base rate of the Bank of England. Unless a property is in a prime area, significant changes are unlikely.
With higher yields, property valuations naturally decrease. In essence, the capital value of a property is calculated by dividing the rent by the yield percentage. As interest rates and yields climb, property values decline. Additionally, the reduced appetite for commercial property investments, resulting in decreased demand, contributes to this decline in prices.
So, are we truly on the brink of a commercial property crash? It’s essential to avoid living in perpetual fear of property market cycles, as they are beyond individual control. Instead, focus on the decisions you make within this economic environment. Personally, I continue to invest, such as in a commercial unit in Bath, albeit with a high yield. This decision reflects my belief in the market’s stability, as I anticipate the property’s value will remain relatively steady.
However, the real fear lies in properties becoming “underwater,” where the mortgage exceeds the property’s value. Such a scenario can transpire when property values plummet quickly. To mitigate this risk, I recommend maintaining commercial property mortgages at around 60% to 65% loan-to-value, or even lower. This precautionary measure offers a safety net, preventing banks from demanding immediate repayment.
Should we fear rising interest rates? Not necessarily, provided your investments are well-aligned with the rate changes. However, if a property crash seems inevitable, consider paying down mortgages to avoid putting undue stress on lenders.
In summary, fearing a commercial property crash is not productive. Instead, concentrate on what you can control. Property markets experience highs and lows, and what works for one person may not work for another. Trust your instincts, analyse the market for yourself, and make informed decisions. Remember, we can’t control the economy, but we can influence our financial choices.
Ultimately, in a market where prices are fluctuating, prioritise your well-being and avoid causing unnecessary stress to lenders. Focus on the factors you can manage, and you’ll navigate the shifting tides of the commercial property market with greater confidence and resilience.
