14/10/06
Perspectives on Commercial Property
The UK commercial property market is becoming more expensive, as shown by a narrower gap between rental yields and gilt yields. Given this outlook, UK investors who are concerned about the sustainability of returns may prefer to look abroad to markets in Europe and Asia which are becoming increasingly attractive. Furthermore, as the returns on existing property look set to be more muted, then exposure to new commercial developments could be a source for additional performance.
After several years of good performance from UK commercial property, a key question for investors is ‘What is priced into the market?’ Over the last few months, property income yields have moved in further and are now, on average, lower than medium term debt funding costs. Such income yields do not reflect all the returns from commercial property, such as the potential growth locked into lease contracts. Nevertheless, many traditional methods of valuing property suggest the UK market is now fully priced. On average since 1997, UK property has offered investors a yield of some 1.5% above the ‘risk free’ rate, for example 10 year government bond yields or 5 year interest rate swaps. 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 to find occasions when property yields have on average been below. 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!
Moving into 2007, we do expect the UK commercial property market will continue to be supported by domestic and international inflows. For example, Real Estate Investment Trusts (REITs) will be introduced next year. From 2007 onwards, we believe the UK market is likely to experience a slowdown towards single-digit returns for investors. 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 environment? One option is to consider other international property markets. Our analysis shows a favourable yield margin over debt costs across the Euro-zone and many overseas markets. Property yields across markets are difficult to compare uniformly given the different range of lease lengths and the range of landlord liabilities in each market. For example, Central Europe typically has three year office leases compared to the ten years that is typical in the UK. That said, the risk premium between different markets is narrowing. This is in part due to the development of REITs, bringing greater liquidity into markets, allowing investors to diversify internationally. Investors also require less compensation for risk when buying a tax transparent share of a domestically managed property fund rather than buying and managing an asset such as an office block directly in a foreign market.
On average across the Australian, Japanese, Hong Kong and Singaporean property markets, office yields offer a margin of more than 2% 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 1% 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 going forward.
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 underway 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 new modern space for expansion and investment yields offer more than 3% over domestic bonds.
Diversification into overseas property could therefore provide superior returns. Another approach for investors to consider is taking part in development activity in the UK or elsewhere, that is developing a property from scratch rather than buying an existing property. Of course, this naturally suggests increased risk and volatility. However, there are a number of approaches which can minimise a fund’s overall risk while still gaining the benefits of potential outperformance from development exposure. Investing in core markets, accurately pin pointing locations to benefit from strengthening occupier demand and closely monitoring supply pipelines are just some of the ways to contain this risk.
Among the key attractions of investing in new developments are low transaction costs, with stamp duty payable on the land or site pre-construction, and access to prime target markets which would otherwise be difficult through the purchase of rarely traded standing investments. In addition, the returns derived from developments are likely to provide a closer proxy for direct investment than listed real estate stocks or commercial mortgage backed securities. This is increasingly important given that, in the current environment, funds are being forced to look further outside the direct market to achieve their target property allocations of between 10% and 15%.
Looking ahead, our analysis suggests less favourable returns from the UK property market over the next few years than from 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 growth of investment flows into Asian markets during 2006/07 and, in domestic markets, development activity is likely to become utilised more often by fund managers as they look to maximise returns.
Anne Leckie, Head of Property Research, Standard Life Investments
First published in Professional Adviser on 14 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