04/09/06
Commercial Property – Will the Good Times Continue?
After several years of good performance from UK commercial property, a key question for investors is "Will these good returns continue?".
Over the last few months, property income yields have fallen further and are now, on average, lower than returns on medium-term debt. These income yields do not reflect all the returns from commercial property, mind you, as they may include potential growth locked into lease contracts. Nevertheless, many traditional methods of valuing property suggest the UK market is now fully priced.
Commercial property is seen as a riskier investment than securities and therefore should – but not always – offer higher annual returns. On average since 1997, UK property has delivered a yield of some 1.5 per cent above less riskier investments, such as 10-year government bonds or five-year interest rate swaps. (At the end of last week, 10-year UK bonds were delivering an annual yield of about 4.8 per cent.)
There is a debate across the industry about the correct methods of valuing the sector in the current environment. We have to go back to periods of much higher UK inflation – think the late 1980s – to find occasions when yields were lower for property investments than 10-year bonds. This reflects the fact that not all of the property return comes from income yields but additionally from rental growth which, in turn, is driven by inflation. Of course, the Bank of England is not expected to allow inflation to get out of hand in the foreseeable future, so there is the possibility for an interest-rate rise.
Moving into next year, we expect the UK commercial property market will continue to be supported by domestic and international inflows. Real Estate Investment Trusts (REITs) will be introduced, for example. From 2007 onwards, we believe the UK market will likely experience a slowdown in returns from the high teens of recent years towards single digits . Although the unsustainability of current returns is widely recognised, the extent of any slowdown could still take some investors by surprise.
How should investors alter their asset allocation in this changing environment? One option is to consider other international property markets. Analysis shows a favourable yield margin over debt costs across some targeted European Union (EU)-member and many overseas markets. On average across the Australian, Japanese, Hong Kong and Singaporean property markets, office yields offer a margin of more than two per cent over government bonds. Coupled with a strong pace of economic growth and below average supply of occupational space, prospective investor returns look attractive going forward.
By comparison, following EU accession, the strong investor demand and yield compression experienced in the Central European office markets of Poland, Hungary and the Czech Republic over the last couple of years means that they now offer a much lower margin of approximately one per cent over domestic bonds. Although expansion of these economies continues to be strong, in our view the persistently high levels of vacant space and the lack of control over construction activity limits rental growth opportunities.
Looking at Western Europe outside the UK, the picture is mixed. A combination of limited supply, strong economic vitality and thus tenant demand in the Madrid market suggests further opportunity for strong returns through rental growth. The sluggish nature of the recovery under way in the German economy is one reason why the office market remains fundamentally oversupplied and tenants are not actively expanding. There are selective opportunities though, such as logistics warehouses in Germany where tenants are actively seeking modern space for expansion, and investment yields offer more than three per cent over domestic bonds.
Looking ahead, our analysis suggests less favourable returns from the UK property market in the next few years compared with several overseas markets. As property yields continue to fall in the UK, combined with rising costs of debt, our measures show the market is becoming more expensive.
Several international markets offer a more attractive yield margin over bonds, as well as the prospect of rental growth. Signs of an increased appetite for global real estate diversification suggest there will be increased investment in Asian markets now and into next year and, in domestic markets, development activity is likely to become used more often by fund managers as they look to maximise returns.
Anne Leckie is Head of Property Research for Standard Life Investments in Edinburgh.
First published on scotsman.com on 4 September 2006.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
Standard Life Investments may record and monitor telephone calls to help improve customer service.
All companies are authorised and regulated in the UK by the Financial Services Authority.
©2008 Standard Life Investments.
RSS Press Articles