26th April 2010
When it comes to property, headlines tend to focus on house prices and the constant shift between ascent and decline. Mirroring this volatility, commercial property has also endured a rollercoaster ride in recent years, displaying the worst aspects of an asset class bubble.
On the fund side, several groups aggressively marketed commercial property four or five years ago – many of us will remember the billboards – and these funds quickly came to dominate.
An additional issue came from the basic lack of liquidity in this part of the market, when investors who had piled into vehicles based on recent performance suddenly wanted out. By its very nature, property is not a liquid asset and cannot be sold immediately in order to return money to investors. This led to several groups having to limit redemptions on these funds, which is obviously never a popular move.
Have you missed the bandwagon?
After a period in the doldrums, several managers began talking of a market bottom last year and were becoming cautiously optimistic again, particularly as valuations have been forced down so low.
But as often happens, the best opportunity to buy assets at the cheapest prices is fleeting and many suggest it may already have passed for commercial property.
Martin Brooks, who runs billions in with-profit funds for Prudential, has been largely nervous on this sector for the past three years, selling around £5 billion of assets over that period. Towards the end of last year however, with capital values down 40%, he began to recover some enthusiasm.
"We started going to auctions again but the big bounce in the sector has already taken valuations back to the level where we felt uncomfortable in the first place," he adds.
So far, it appears investors are shunning any such caution and beginning to herd again (link to Cherry's piece Mind the Gap) Just months after the sector stated showing healthy signs, property was the best seller in the last quarter of 2009 and also January this year.
Influx of foreign investment
This newfound thirst for commercial assets property is also evident among overseas buyers – who many feel are largely responsible for driving prices up – with several capitalising on distressed opportunities.
Recent research shows 73% of commercial purchases by value in central London last year were by foreign investors. In the previous 10 years, only 49% of investment originated overseas.
Flagship deals in this flurry of activity have included the National Pension Service of Korea's acquisition of the HSBC tower in Canary Wharf and sale of the US embassy to a subsidiary of Qatar's sovereign wealth fund.
So what now for commercial property?
So what now for commercial property – and more importantly, have the best opportunities to enter the market already been and gone?
Several managers continue to report increasing capital values, particularly for property at the prime end of the market, despite a challenging macroeconomic situation in the UK.
At Schroders, Jim Rehlaender manager of the group's Global Property Securities fund is currently overweight in US and Asian markets. He believes property companies in Hong Kong and Singapore remain the best capitalised globally and look set to continue benefiting from economic recovery.
"Within Europe, we are more optimistic about the potential for greater-than-expected upside over the next 12 months, now that the risks for the finance sector have been reduced and the banks are somewhat more willing to fund existing high quality clients at lower rates," he explains.
"However, there is a mixed outlook for countries in Europe as property markets have become highly divergent in their pace of recovery. France and Germany appear to have stabilised and are beginning to recover while Spain and Eastern Europe continue to struggle.
"We are less positive on the UK: although a recovery is imminent, we believe the pace of this may be hampered by high consumer debt levels."
HSBC's multi-manager head Guy Morrell believes commercial property returns should continue their recent strong run before dipping next year. Overall, he sees prospective performance on a five-year view as providing a reasonable premium over risk-free assets, although risks remain.
Morrell, who runs the group's Open Global Property vehicle, is expecting the strength of investor sentiment to continue and feels competition for prime assets will put further downward pressure on yields. "This will result in stronger returns over the short term but the amount of refinancing that needs to be completed by 2011, combined with the strength of the pricing recovery, may encourage more sellers," he adds.
"We therefore expect the rate of yield decline to slow, with the possibility of a rise in late 2010/early 2011 resulting in a dip in performance in 2011. Thereafter, we expect the market will then deliver modest, single-digit total returns dominated by income."
At the end of 2006, HSBC signalled UK commercial property was unattractively priced and the 44.2% correction over two years to last July resulted in yields rising above its view of long-run fair value.
In early 2009, Morrell said prospective long-term returns had become more attractive than at any time over the previous five years but performance materialised quicker than expected in Q4. "This was driven by strong investment demand and falling yields, despite the continued weakness of occupier markets and rental growth," he adds.
"We expect occupier markets to remain weak in the short to medium term, with further rental declines, but now expect positive rental growth in 2011 although there will be widening divergence between subsectors."
Not everyone is quite so bullish though. Writing for MoneyWeek, David Stevenson encourages investors to sell out of commercial property .
His argument basically rests on the fact that rental income is under threat from ongoing economic weakness, leading to rising tenant defaults and even buildings standing empty.
Despite this, several comments on his piece suggest commercial property funds a
re attractive at present, with yields particularly solid compared to current rates available on cash.
And the facts arguably speak for themselves. Over the 23 years from 1987 to 2009, UK commercial property has delivered a total return of 8.6% a year. It is also currently yielding 3.8% above UK gilts and offers strong diversification benefits as its returns are lowly correlated with the other main asset classes.
Several advisers still push this as the main case for buying commercial property and feel decent ongoing income should be the main attraction rather than potential for massive capital gains. While this market has come off its lows of last year, many believe it remains decent value, suggesting long-term investment could be worth another look.