Value to be had in ‘stressed’ commercial property sector

29th October 2010

Certainly at a time when bond yields are very low, cash deposit rates offer little reward, and equity dividend payments remain uncertain,  commercial property, despite it being exposed to a challenging outlook for the sector too, does appear to have merits considering its potentially high income generating characteristics.

According to Marcus Langlands Pearse, director of UK property at Henderson Global Investors, trends favouring commercial property are unlikely to change significantly in the coming months, although he suggests investors factor in some modest upward movement in UK government bond yields in 2011, which will impact upon property's relative pricing to the risk-free rate.

"In the mid-term, performance will become increasingly driven by a portfolio's ability to generate rental growth through the quality of its buildings and strong asset management," he says.

Focus on quality

The focus on quality in commercial property investment is palpable though, with risk aversion remaining very prevalent. Langlands Pearse says the effect of this has been the development of a ‘two-tier' market, with investors and lenders focusing almost exclusively on the prime property market, which is regarded as reliable, well-managed and armed with long leases. That focus on the prime sector has been at the expense of the secondary market, characterised typically as decent buildings, including standard retail space, but with perhaps weaker covenants or lease agreements.

Langlands Pearse, who manages Henderson's UK Property Unit Trust, says such reticence on the part of investors reflects a weak economy and an uncertain outlook, with investors worrying over whether the private sector will be able to offset the consequences of large scale de-leveraging across the government, business and consumer sectors. "Although continued economic uncertainty is likely to widen the gap between primary and secondary assets, we are of the opinion that quality assets with long leases and quality tenants will continue to be reliable performers," he says.

Certainly recent performance by the sector has been encouraging. According to the Investment Property Databank (IPD) All Property monthly index for September, capital values have now recovered 16% since last year's market trough, although that is still 35% down from their peak in 2007.

Flat secondary market

Recovery has not been uniform across the wider market, with prime assets performing much better, up 26%, mainly because of greater instances of guaranteed rental growth and with cast-iron tenant demand.  On the other hand, the secondary market has been broadly flat over the same period, a reflection of the greater perceived risk of write-downs caused by poor demographics, lower quality buildings, oversupply, a less economically stable tenant base and increased voids and rental declines.

Langlands Pearse says: "Commercial property may have recorded a moderation in yield-driven capital growth, but because the sector looks historically well priced, we believe commercial property still offers an attractive income-led return, albeit driven largely by the prime asset market."

He anticipates further pain in the secondary/tertiary market into 2011. This, he believes, will weigh heavily on broad sector rates, adding to a concerted investor preference for core, less over-rented markets.  

Prime versus non-prime

In considering the impact of the government's recently announced public spending cuts, which will take effect from 2011, Langlands Pearse says they will most likely have a disproportionate influence on a number of office markets in which either the share of public sector administration jobs is much higher than the national average, or more importantly, in which leasing markets have been driven by public administrative take-up.

"Once again, the distinction between the prime and the non-prime will be significant. Second tier cities, such as Newcastle, Liverpool, Nottingham and Sheffield for example, will be particularly badly affected, but there are also examples of markets in the south where public sector take up has been critical to demand for space, for instance Croydon."

Property consultant Clutton recently also warned about regional gaps in performance opening up in an interview with the MoveChannel.

Having said that, Langlands Pearse notes that current forecasts indicate acceleration in business services output, with improving profit margins and confidence among regional businesses.

Currently, UK institutions and overseas investors remain by far the most active investors in the UK commercial property market, although at historically deflated volumes. "As the market becomes increasingly polarised, equity-rich investors are best suited to cope with the competitive prices that prime assets will transact for," says Langlands Pearse. 

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