Weekly outlook

Laying the foundations of strong property returns
 
By Tom Stevenson, 10 December 2008

Will 2009 be a vintage year to get back into commercial real estate?  Last week this column highlighted the income available from corporate bonds and high yield equities. Today we turn to another part of the market where income-hungry investors might search for the yield that deposit accounts can no longer offer – commercial property. As with both equities and corporate bonds, recent price falls have made the income from commercial real estate increasingly attractive when measured against the cost of buying an underlying property.

"Timing property is more difficult than hopping in and out of the stock market" Tom Stevenson

The average income yield for a buyer of commercial real estate has been 6.4% since 1981. The boom in property investment pushed this yield lower than average for the five years from 2003 to 2007 (see the chart below), but the recent pretty savage correction in prices has brought the return above par again. Some transactions are already being priced at yields of 7.5%, still short of the peak reached in the early 1990s downturn but an attractive income for a long-term investor to secure in today’s low-yield environment.

Between the commercial property market’s peak in June 2007 and October this year, capital values fell by 24.5%, according to the Royal Institution of Chartered Surveyors (RICS), with declines recorded in all the three main classes of property – offices, retail and industrial.

The bad news for investors is that, as yet, there is no evidence that the falls are coming to an end, or even slowing much. RICS reports an acceleration in the rate of decline from around 1.2% a month in the summer to 4% in October. The rate of decline is much more rapid than in the last major property slump in the early 1990s.

RICS forecasts that average property prices will continue to fall in the short term for two reasons. First, because investors will demand an even higher income to compensate them for the risks of investing in property as the economy heads deeper into recession and the rate of tenant defaults rises. Second, because recession will inevitably lead to lower average rental growth.

Further downward pressure will be put on the sector by ongoing redemptions by property fund investors, which will force some fund managers to sell buildings to fund repayments. As banks continue to rebuild the strength of their balance sheets, it is also likely that a proportion of the estimated £200bn loans outstanding on commercial property will not be rolled over and the affected properties will be sold into an unreceptive market.

Putting all this together, a peak to trough fall in property values of around 50% looks possible by the end of 2009. Although this would be a bigger cumulative downturn than in the recessions of both the 1990s and 1970s, some within the industry believe future valuation falls are largely being factored into current transaction values.

That doesn’t sound like a particularly attractive backdrop for an investment in commercial property but there are several reasons why investors should start to think about building some exposure to the sector next year.

The first is that, as with corporate bonds, the income from commercial property is starting to look compelling compared with that on offer elsewhere. It compares favourably with the low single digit returns available on cash, is around twice as good as the 3.6% offered by a 10-year UK government bond and is substantially higher than the 4.6% average yield of a FTSE 100 share.

Because the current downturn is being driven by both a weak occupational market (as companies retrench and lay off staff) and by a drying up of liquidity, values should be driven lower and more quickly than would be justified by a run of the mill economic downturn. This means that the bounce back could also be bigger and quicker than usual. Property investors want to be in place in good time to catch the return swing of the pendulum.

Timing the commercial property market is much more difficult than hopping in and out of the stock market, which prices its assets daily and benefits from good liquidity. Seasoned investors talk of “buying the U” in property, which means buying a little early, while prices are still falling. They do this because the final phase of the downturn can be the only time when some prized assets ever come on the market and they are prepared to take a small hit in the short term to lock in the gains that will come through the next upswing.

Finally, the UK market could surprise on the upside thanks to the recent sharp falls in the value of sterling, which have made British property look extremely attractive to overseas buyers. In dollar, euro or yen terms, the UK property market has already fallen by around 50% since June 2007.

Warren Buffett famously advised investing when others were fearful and selling when others were greedy. Over the next year or so, there will be no shortage of fear in commercial real estate markets and long-term investors will see opportunities that will not recur until the property cycle has run its course once again.

No-one is calling the bottom of the commercial property market just yet but that moment is fast approaching.