Financial Adviser - Banking on Commercial Property’s Sustainable Yield
What does the recent volatility of financial markets imply for commercial real estate investors? Following 14 consecutive years of positive returns from UK commercial property, investors were alerted to what the future held when equity market volatility increased sharply in the second half of 2007. Similarly, the equity market rally that began in March 2009 indicated a recovery in commercial property values was to follow. So does the current heightened equity market volatility suggest that commercial property investors should brace themselves for a further lurch downwards and, if not, then where might the property risks lie in an evolving economic landscape?
The recent bout of financial market volatility has been influenced by two over-riding concerns. Firstly, a rising tide of economic indicators pointed to a marked slowdown, or reversal, in economic activity in most large economies, China and Brazil being the exceptions. Secondly, that political and central bank leadership was demonstrating little ability to effectively respond to the deteriorating environment in economic activity, addressing the US debt ceiling and declining appetite for European sovereign debt financing.
Commercial property returns are strongly correlated to economic activity. Whether it is bums on seats in offices, consumers walking through shopping centres or manufacturers producing widgets in warehouses the direction of the commercial property cycle is inextricably linked to the ebb and flow of a country’s economy. The spew of economic indicators in early August did not therefore augur well for the outlook for commercial property. Latterly economic indicators have provided some relief that a double dip recession in key mature economies is less likely. Nonetheless, the economic growth of highly indebted countries (USA, UK, Japan and much of the Eurozone) will likely remain sluggish for some time to come.
What continues to concern investors is the lack of political leadership and limited policy tools available to address the risks of a potential deterioration in economic activity and the more likely stresses that will continue to plague sovereign debt financing, particularly in Europe. As a result of a continuation of these latter concerns, property investors and fund managers are taking a more risk averse approach to investing which is likely to stay for some time. Well located office and retail property in central London let to strong tenants on long leases will continue to attract strong investor interest despite capital values being bid back-up to close to pre-recessionary levels. However, investors are becoming less bullish about future rental growth in the London office market as the banking sector embarks on a fresh round of sizeable job cuts and, whilst new supply of offices is expected to be well below historic norms over the next couple of years, a sharp increase in new office towers will be delivered to the market in 2014 and 2015.
In addition to investors seeking prime quality property they are also looking to increase their exposure to less risky bond type property. There are a number of property types that fall into this category, e.g. supermarkets, hotels, leisure and logistics, but they all have commonality of long leases (typically 20-30 years), strong occupiers, and rental indexation to either the Retail Price Index (RPI) or Consumer Price Index (CPI). On the flip side, and in a reversal of an increased risk appetite earlier in the year, we are seeing investors shun weakly occupied and vacant secondary or tertiary commercial property in most locations. Additionally, recently dusted off development plans are being put back on the shelf unless occupiers can pre-commit to schemes. This is likely to include the postponement of some of the central London office towers that were being readied for starting onsite over the next 6-12 months with delivery some 3 years hence.
None of this fully answers the question of whether direct commercial property markets face the falls experienced by equity markets in August. While the economic background has clearly deteriorated, at this stage expectations of rental growth have been reduced to lower levels. While secondary and tertiary property markets are expected to experience some capital declines into 2012, prime property is expected to hold-up reasonably well given the substantial income yield margin property offers over bonds, both government and corporate. By way of example, the current yield on a supermarket let to Tesco for 25 years with rents indexed to RPI is c.4.5%. The redemption yield on Tesco RPI linked bonds maturing in 25 years is c.2.0%. The supermarket clearly needs an illiquidity premium given the time and cost it may take to buy and sell the property but this will be substantially less than the current differential between the two asset classes. It is worth bearing in mind that were a large supermarket chain to go bust the supermarket owner is able to re-let the property to another retailer or ultimately change its use to another property type, e.g. residential, the bond holder is left waiting to see what is left of the company’s assets at the end of the courts process.
Commercial property does not face the same risks as it faced when confronted by the latest recession. The average income yield on UK commercial property is currently 6.25%, higher than immediately prior to the recession when it was 4.6% (UK property currently offers a 3.75% margin over 10 year gilts, immediately prior to the downturn it actually yielded less than gilts with a negative margin of -0.7%). Additionally, despite the increased number of cranes on the London skyline, the development pipeline for supply completions remains fairly muted for the next couple of years.
Where there is greatest cause for concern for property investors over the next 12-24 months is in the likely reduction of bank lending to commercial property investors, particularly in Europe. Europe faces the greatest risks because the main issues of budgetary deficits and poor economic growth are failing to be addressed by the political leadership in the countries affected (Ireland perhaps the exception). We are therefore likely to see further incidents of credit contraction in Europe until more decisive action is taken. Whilst not all property investors use debt, the majority of UK property trusts are not leveraged or geared for example, bank debt is an important source of capital for commercial property investors. Turning-off the debt tap, or a substantial increase in credit spreads, will have a knock-on impact on property values as debt investors lower their bidding prices to compensate for lower loan-to-value covenants and higher debt costs.
Over the last 40 years UK commercial property has delivered annualised returns to investors of 10.8%pa, according to IPD, compared to a return of 12.8%pa from UK equities and 10.1%pa from Gilts. The majority (60%) of property’s return came in the form of income. In a low growth and low inflation environment one can be confident that income will be as, if not more, important to property investors over the next few years. Whilst there maybe continuing uncertainty about the pace of economic growth shown by debt laden countries what seems clear is the attractiveness of commercial property’s sustainable income yield for multi-asset investors and the recent refocusing of property fund managers towards security and longevity of income is likely to remain a theme for some time to come.
Andrew Jackson, Head of Wholesale and Listed Real Estate, Standard Life Investments
First published in Financial Adviser 15th September 2011