Investment Week - Property – An Anchor in the Storm
Long held investment beliefs have faced some major challenges in the current environment. The risk free rate, commonly thought of as the yield on government bonds, is not as risk free as once presumed in some markets. Heightened volatility in equity markets has meant that equity market moves that would have been synonymous with significant corrections in the past are no longer considered unusual daily movements. In this environment, reasonable quality real estate is looking like a positively safe haven for investors.
According to the latest Investment Property Databank (IPD) real estate index, UK commercial real estate prices have been relatively flat from the start of this year whilst the other element of total returns from real estate, the income component, has been running at close to 0.6% per month from the end of last year giving a total return of 6.4% for the year to date (up to the end of September). At the time of writing, real estate is one of the few asset classes to provide reasonable positive returns over the year to date. A key question for investors is if this positive performance will be maintained.
Commercial real estate returns are inextricably linked to the health of the underlying economy. If firms are hiring and expanding then they require more space and are prepared to pay higher rents for this space if expansion space is constrained. Investors need to assess the present situation where economic activity looks to be stagnating and companies investment plans are generally on hold in the context of the heightened economic uncertainty. We believe that in the absence of another recession, UK commercial real estate looks well placed to deliver reasonable relative returns. Unlike the post Lehmans correction of 2008, prime quality UK commercial real estate is likely to continue to provide resilience in the current environment. Prices for buildings remain about a third lower than they were in 2008 and a yield of around 5% to 6% for prime quality properties does not look demanding from a pricing perspective. Furthermore, against a yield of 2.6% or thereabouts from government bonds, the margin of around 3% would appear to be adequate compensation for real estate’s illiquidity. The construction pipeline, or future supply, is also relatively constrained.
In the current environment, risk aversion remains elevated and investors continue to focus on prime real estate and less risky bond type real estate. There are a number of property types that fall into this category, including supermarkets, hotels, leisure and logistics and these assets generally 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, in a reversal of an increased risk appetite earlier in the year, investors are shunning 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.
Although tenant demand has wavered recently in some of the more volatile markets such as the City, voids (or vacant space where the rent is not being paid) have remained relatively stable at around 10% of assets (according to index provider Investment Property Databank, IPD) Income from better quality properties continues to be resilient and should remain compelling for investors. Income from tertiary properties however, remains vulnerable to further decline and prices for these types of assets may adjust downward as a result. This adjustment is also likely to be accentuated if banks release a lot more of the poorer quality assets that they hold, a process that appears to be gathering momentum. At present, selecting assets is not necessarily about allocation to retail, office or industrial sectors but more about location, building specification and importantly, the quality of tenants. Large dominant shopping centres continue to experience strong demand from retailers. For example, Westfield Stratford recently opened with more than 95% of units let. Rents have been significantly more resilient in large centres compared to the dire situation in many provincial towns.
For multi-asset investors, real estate assets that are well located with reasonably financially secure firms as tenants are likely to continue to produce a compelling positive sustainable income yield that compares favourably with the depressed yield on a range of other “defensive” type assets. Lastly, it is an often forgotten attribute of property that if the tenant company goes bust the property investor is still left with an asset that can be re-let unlike an equity investment where you might be left with nothing.
Simon Kinnie, Senior Real Estate Analyst, Standard Life Investments
First Published in Investment Week on 07th November 2011