Is commercial property an investment winner?
Even though the bottom has fallen out of the property market, people still don’t seem to have fallen out of love with property, with many prospective buyers simply waiting for the right time to buy. But how do investors view the prospects for commercial property?
Few asset classes divide opinion as much. While those in favour argue it offers much-needed diversification and the potential for decent long-term returns, critics claim it is over-hyped and can lose investors a fortune.
Confusingly, events of the past decade can be interpreted to support either argument. During the boom years, both buildings and property company shares soared in value on the back of investor demand for anything related to bricks and mortar.
But it has been a different story since, with falling stockmarkets, the credit crunch and the global recession combining to deliver such a massive blow to this once popular area of investment that some observers fear it may never fully recover.
The sector’s fall from grace has certainly been dramatic: the bumper double-digit returns achieved in 2004, 2005 and 2006 were replaced by falls of 3.1% and 22.3% in the following two years, according to Investment Property Databank.
Commercial property values are currently a whopping 40% lower than at their 2007 peak, and many industry figures are expecting more pain over the next few months before the market stages anything resembling a recovery.
The under-pressure retail sector – which has seen shops going to the wall at an alarming rate – has been the worst hit, with a 44.4% drop in values, but this is only marginally worse than offices (42.6%) and industrials (39.4%).
These problems have also been reflected in the losses recorded by unit trusts that invest in property companies. Over the past three years even the best-performing portfolio has lost a staggering 16%. The worst has shed almost 60%.
Investment houses – many of which were busy launching dedicated property portfolios at what turned out to be the height of the boom – are now staring at negative returns and fielding calls from angry investors, many of whom have been rushing for the exit. In fact, so many stampeded to get their money out of these funds that some institutions were forced to put a stop on withdrawals to protect the interests of the remaining investors.
The fact that so many investment funds specialising in property were launched in such a short space of time has also come in for criticism – but such attacks are unfair, insists Ben Yearsley, investment manager at broker Hargreaves Lansdown.
“Investment houses were simply bowing to investor demand,” he says. “It looks daft in hindsight, but people wanted property, so you can’t criticise companies for launching funds to meet the demand.”
Even so, for investors who embraced the sector it has been such a painful time that questions might need to be asked about the quality of advice dispensed.
“It became the most popular new asset class for investors,” says Andy Gadd, head of research at financial adviser Lighthouse Group. “Some advisers were recommending an exposure of between five and 20% to commercial property, for clients looking for a balanced asset allocation.”
Not surprisingly, the downturn has affected investor confidence. Property was by far the worst-selling sector in November and December last year among retail investors, according to figures compiled by the Investment Management Association (IMA).
But is this an over-reaction? What is the truth about commercial property? Is it a great diversifier that can provide excellent returns over the longer term or a busted flush? Can investors still make money or did the last chance vanish when the recession arrived?
Before making any judgments, it’s important to understand how the sector works. The first point is that it has nothing to do with residential property or house prices. Commercial property, of which there is estimated to be about £762 billion worth in the UK, is primarily made up of three sectors accounting for 80% of the market – shops, offices and industrial.
In addition, there are several smaller areas such as leisure parks, restaurants, pubs and hotels.
In its simplest form, commercial property investment can be divided into two distinct parts: direct property and shares held in property-related companies. While both are influenced by broadly similar economic factors – unemployment, interest rates, consumer confidence, and the general demand for space – there are major differences between them.
The returns on direct property investments are made up of rental yields and the (hopefully) increasing value of individual buildings. Returns on many property investment funds, however, are far more closely aligned to movements in equity markets.
Investors can get access directly and indirectly in a number of ways. For those with large sums of money, it is possible to buy actual buildings, such as shops and factories, which can then be rented out to businesses.
Becoming a landlord in this way means having to manage the building, find suitable tenants, negotiate lease terms, review rents and undertake any refurbishments or repairs that are required over time. In exchange, investors receive the rental income. However, for the vast majority of investors this simply isn’t feasible as they don’t have the money, time or expertise.
Most private investors therefore gain exposure to commercial property by buying unit trusts or shares in quoted property companies. This provides access to a range of property and professional management skills, and involves considerably less risk than being a landlord.
“The easiest way to access commercial property is through a collective fund such as a unit trust,” agrees Geoff Penrice, an adviser at Bates Investment Services. “Investors can benefit from investing in a diversified property portfolio, and can invest relatively small amounts.”
However, as Andy Gadd points out, people need to know what they’re buying. “It’s important to ascertain whether the fund invests directly in property or in the shares of property companies, because not all invest in bricks and mortar,” he says. Indeed, no two property funds are exactly the same – even if they both appear in the recently launched IMA property sector. Some concentrate on actual buildings; some are focused purely on equities; while others are hybrids.
This will obviously affect managers’ views. For example, Andrew Jackson, manager of Standard Life’s hybrid Select Property fund, has been reducing exposure to bricks and mortar since the end of last year because he is convinced that listed investments will provide better returns.
“I expect listed property companies to outperform direct property over the coming year, so I have had to recycle my money to maintain the fund’s performance,” he explains. “Listed markets also tend to recover six to nine months ahead of direct property values.”
At the end of the day, investors’ decisions on whether – and how – to invest should be based on their long-term goals and view of current valuations, maintains Darius McDermott, managing director of Chelsea Financial Services. “Commercial property is a lot cheaper than it was a few years ago, but we could well see it continuing to fall for the next 12 months,” he says. “Investors need to be willing to accept that kind of volatility.”
The questions facing those who like the idea of commercial property seem straightforward: Where do we go from here? Has the market bottomed out? Are valuations likely to recover strongly from here? Which area looks the most attractive? But, unsurprisingly, opinions vary enormously.
Anthony Bolton, the legendary stockpicker who successfully ran the Fidelity Special Situations fund for the best part of three decades, called the bottom of the commercial property market at the end of last year. His optimism was based on the fact that the availability of yields more than 4% above the Bank of England base rate compensated amply for the risk that some tenants might go bust.
Others are not quite so optimistic. Guy Morrell, head of Multimanager, UK for HSBC Global Asset Management, does not believe the direct market has yet reached a floor. Nor does he necessarily expect a strong recovery in the short term. However, he recently bought the Threadneedle UK Property Trust to hold in the HSBC Open Global Property fund – the first time since launch that this portfolio has had any exposure to a UK direct property fund.
Morrell cites the experienced and highly rated team, and its high cash weighting that can be deployed effectively to take advantage of current market weaknesses. “It should result in superior performance, relative to other UK direct property funds,” he adds.
The fact is that it’s impossible to time the absolute bottom of the market, points out Penrice. The horrendous falls of the recent past are no guarantee against further bad times to come.
“Commercial property values have fallen more than 40% over the past two years, so they are now more attractive,” he says. “Unfortunately, prices are still falling and the overall drop could be 50% before prices stabilise.”
The outlook certainly isn’t very positive, according to the most recent consensus forecast drawn up by The Investment Property Forum, which reveals that the projected total All Property return for 2009 has fallen to a dismal -15.1%. “This is driven by reductions in both capital and rental growth figures for the year,” states the report. “The positive total return forecasts for 2010 have fallen again, with shopping centres the most significantly revised sector.”
Elsewhere, the amount of floor space available for occupation rose at the fastest pace for a decade during the first quarter of this year, while occupier demand fell, according to a survey by the Royal Institution of Chartered Surveyors. “The ongoing contraction in the economy alongside rising levels of available space continues to reduce surveyor expectations towards achievable rents,” it says. “Rental expectations were most gloomy in the office market.”
However, George Shaw, manager of the Ignis UK Property fund, suggests that the sector may come to the fore again if inflationary pressures emerge – particularly as a result of the Bank of England’s policy of stimulating the economy.
“It’s generally acknowledged that quantitative easing is likely to trigger inflation over the medium term,” he says. “That means tangible assets will be particularly important going forward, and income will be the key component of returns.”
Portfolios with a high, stable and secure income stream are therefore likely to outperform over the next two to three years – and that is a benefit that commercial property as an asset class can offer, he adds.
So what is the conclusion? In essence, the fortunes of the commercial property sector are dependent on an economic recovery, says Andy Gadd. Prices may have fallen heavily and the balance sheets of many companies are still undergoing repair.
That said, if an investor has chosen commercial property for the long term, then what happens over shorter timeframes is not so important, he argues. Equally, for those buying into funds, the recent valuation falls can present good opportunities.
“I suspect it is still too early for private investors to buy heavily into property,” he adds. “However, a diversified portfolio should not necessarily ignore this sector altogether – especially where income is a requirement.”
Ben Yearsley agrees, pointing out that investors don’t need to panic about getting in when the market is at the absolute rock bottom, as the sector does not usually spike upwards overnight.
“There will come a time in the next six to 12 months when it will be the right time to get back in, but now might be a bit too soon,” he says. “You can wait for prices to go up before getting in, without missing too much upside.”
New Star UK Property Fund
Recommended by Andy Gadd, head of research at Lighthouse Group
“New Star has been acquired by Henderson Global Investors, which manages more than £9 billion in property investments and has a sophisticated property investment management platform, including a research team with sector specialists.”
Threadneedle UK Property Trust
Recommended by Geoff Penrice, an adviser at Bates Investment Services
“The fact that the market has fallen so much, and there are a number of distressed sellers, means there could be some bargains. So it’s worth looking at funds like this one, which has a high level of cash and can take advantage of good deals.”
Aviva Investors Property Trust
RECOMMENDED BY Darius McDermott, MANAGING DIRECTOR OF Chelsea Financial Services
“This fund has one of the best long-term track records in delivering returns for investors, so is worth considering.”
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
A catch-all phrase that can range from assessing the price of a property or vehicle before offering it for sale or the net worth of assets in an investment portfolio to the prices of shares on a stock exchange.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.