The prospects for capital growth in the UK’s commercial property market are limited but there are opportunities for discerning investors who follow appropriate strategies, writes Richard Kirby of F&C REIT.
UK commercial property has, quite rightly, been depicted as an asset class delivering a relatively high and stable income stream with the prospect of some capital growth. The record of the last 30 years bears this out with all property total returns averaging 9.2% per annum (pa), incorporating a 2.5% pa capital growth element.
There has been positive capital growth in 23 of the past 30 years, it has driven total returns in 11 years but only in seven years has it moved into double-digits. It is also a highly volatile component of total returns. IPD annual data for 1981-2010 shows capital growth varying from 23% to -26%.
The first year of the current recovery saw a sharp rise in capital values but the past 12 months have witnessed a much more subdued performance with annual capital growth of less than 4% in the year to June according to the IPD Quarterly index. Although capital values are still well down on the market peak another surge in market performance is not anticipated.
The latest Investment Property Forum (IPF) consensus forecast published this month predicts that positive capital growth will be sustained at the all-property level over the next five years but that it will average a meagre 1.4% pa.
The most bullish forecast is a 2.9% pa average, which hardly sets the pulse racing. Indeed, certain parts of the markets are looking vulnerable to falling values.
The latest IPD quarterly data shows that offices outside London, as well as shops and industrials outside the larger region of London and the southeast, have all delivered negative capital growth over the year.
Fewer prospects outside London
On the face of it, it would appear that outside central London, the prospects for capital growth are very limited. Looking at UK commercial property at the segment level, that may well turn out be the case, at least for the next couple of years.
Economic growth is expected to be slow and uncertain in the UK. London may well outperform and IPF forecasts are for City and West End office capital values to rise by 3.6% pa and 4.0% pa respectively in 2011-15, helped by tight new supply in core areas and London’s international role in the global economy, but it may be front-loaded.
Development activity is starting to revive and concerns about the global economy and the resilience of the financial system may limit London offices’ outperformance, especially in the City. Even the most bullish commentators see capital values returning to single digits after 2013 while the bears are expecting prices to fall as soon as next year.
The central London office investment transactions market has been a source of strength but at current yield levels, it may be that growth prospects are largely priced in. The central London shops market is driven by different factors such as tourism and may well prove more resilient.
Focusing on fundamentals
Analysing UK property by geography or segment is a convenient shorthand but obscures as much as it illuminates. Every property is different and in property investment it is important to focus on the fundamentals of the asset as well as its sector and location.
We believe that selectively it is possible to add value to property in the current market and there are three main ways in which this can be done:
1. Identifying new types of property investment
3. Re-positioning assets
All these have the potential to deliver capital uplifts but they have their risks as well.
One option is to gain the first mover initiative and ‘get in on the ground floor’ for an asset which is growing in importance and becoming institutionally acceptable. The classic case in the past was retail warehousing which moved from a minor part of the retail market to take a growing share of the retail investment universe. In 1981, retail warehousing accounted for just over 2% of retail property in the IPD Annual index; by 2010 it was 38%.
Leisure is another area that has seen long-term outperformance in capital growth as it became increasingly institutionally acceptable as a property investment asset. Today, student housing is carrying on that tradition. Investors are attracted by high occupancy rates, long leases and attractive yields. This is a market with sound fundamentals as student numbers increase and universities move away from the role as landlord but it also requires extensive due dilligence at the asset and town level.
There has been some aggressive marketing in this area and there is a danger of localised oversupply especially if provision is undertaken without links to an academic institution. Performance data for any new sub-sector is very limited and this can be a problem for ‘first movers’, by the time the asset type is bench-marked, it has reached a certain level of maturity.
If unable to buy, why not build? For those with long memories, the development excesses of the late 1980s and their effect on capital values in the early 1990s, may strike fear into the heart. IPD published research last year on the performance of 3,500 development schemes which indicated that projects completed since 1983 have, on average, underperformed standing investments. IPD is in the process of updating its study and the results are expected later this month.
On the information currently available, this average reflects a wide range of outcomes. Office developments in the West End and mid-town delivered a total return of 14% pa, roughly five percentage points higher than the standing investment average for that part of the market at that time but 10% of projects were flops, delivering a total return of minus 18% pa or more.
Development is capable of delivering growth in capital values but given the wide range of outcomes, timing, sector selection, asset selection and manager expertise are all critical.
The third method of delivering an uplift in capital values is by repositioning the asset in the marketplace. Raising a secondary asset (defined as one on the 75th percentile of the IPD Quarterly index in yield terms) to ‘average’ within its segment can theoretically move yields inwards markedly, translating to 150 basis points at the all-property level. By reducing voids, lengthening leases and letting to tenants with stronger covenants, the attractiveness of the asset is increased, income rises, the rental tone improves and capital values benefit.
There are limits to this approach, not all properties will be capable of significant improvement but as the chart above shows, the scope is there and its scale dwarves the yield shift implicit in the forecasts of market total returns for property. This approach is particularly appealing in the current market.
Property is a ‘real’ asset and it needs attention to sustain its value and continuous review of its market prospects. This has not always happened. The period prior to the 2007 peak saw some properties traded at breakneck pace to take profits, often to debt-backed buyers, with little attempt at improving the underlying fundamentals of the asset.
The scale of the banks’ property debt problem is massive and has been widely debated. The banks are starting to regularise matters but it is estimated by the IPF that the work-out period will be five to 10 years and the banks are expected to cut back their property lending significantly; one projection is for a 30% disinvestment on £200 billion of loans.
These properties will come to the market over time, not as forced sales at fire sales prices but as a range of properties in various states of health. De Montfort estimates that the majority of this loan stock is secondary and it is probable that some is obsolete. Within that volume though, there are likely to be assets capable of improvement. Each property has to be looked at on a case-by-case basis by experienced professionals.
The UK direct commercial property market has been trading in a narrow range for the past year with limited capital growth. We expect performance at the aggregate level to be driven by income but there will also be opportunities to deliver capital growth in selected parts of the market by following certain investment strategies, all of which will be strongly stock-specific.
Richard Kirby is director, property funds, at F&C REIT.