Can commercial property really rise from the rubble?

The UK commercial property sector is a sort of mirror to the economy and is divided into three main segments: office, industrial and retail.

As the economy struggles to pull out of recession, the market for properties that businesses occupy is showing signs of turning the corner.
So it's hardly surprising that the outlook for the commercial property sector in the year ahead depends, to a large extent, on the prospects for the economy.

If the green shoots of recovery take hold, companies will need more office space, more warehouses and high street shops, and prices will be pushed up.

If we scrape along the bottom, or fall further, the number of empty properties and 'to let' signs will proliferate and for investors the picture could be bleak.

Commercial car crash

The past two years have been a spectacular car crash for commercial property. Between July 2007 and July 2009, IPD's All Property index recorded some 25 consecutive monthly falls in the total return from property - during that time capital values plummeted by 44.2%; a trough far deeper than during the previous major decline from 1989 to 1993.

That sharp drop reflected the heavy reliance of commercial property on debt and the impact of the credit crunch in choking off funds.
Meanwhile, property funds that sold themselves heavily to retail and institutional investors before 2007 were forced to impose penalties or block redemptions to stem the tide of investors heading for the exit doors.

Commercial property had been sold as an antidote to the volatility in the equity market, but its downfall was every bit as precipitous.
The upside is that yields expanded significantly during the period of falling returns, from around 3% just before the plunge to up to 8% at the end of it. With low returns on other asset classes, property started, unsurprisingly, to look attractive again.

By spring 2009, a number of the industry's big hitters - Sovereign Land, London & Stamford and Max Property (backed by Prestbury Group's Nick Leslau) - were involved in raising new 'vulture' finance to invest in some of the distressed assets in the market.
When IPD announced in September that its index had shown a modest 0.2% growth in capital values in August, it was seen by many as confirmation that the market had turned.
By October, with three consecutive months of gains, there was further evidence of a revival in the sector.

Land Securities sold a third of the Bull Ring shopping centre in Birmingham for close to £210 million, and when Lloyds Banking Group put Glasgow's Silverburn shopping centre on the market - a property it had foreclosed on at the beginning of 2009 - there were reported to be more than 40 bidders in the frame.
Since then, a number of retail property funds have moved to remove barriers to exit and there's been a spate of new funds launched.

Nevertheless, with investors, including significant overseas players, looking to commit large sums of money to the sector, concerns have come from two sides.

On the one hand, there is some doubt whether commercial property really has turned the corner, not least in the light of the continuing uncertainty about the economy, while on the other hand some fear that a new investment bubble is underway.

Fair value

Roger Bootle, managing director of Capital Economics, says medium-term prospects for commercial property are improving: "The market is in a much better position than it has been for a number of years from an investment perspective.

"I'm more bullish about it than I have been for a long time. Overall, the market is just about fair value and should provide investors with reasonable returns in the medium term."

But he adds: "Signs of excessive enthusiasm are gathering and there is a significant danger of a mini-bubble followed by a period of capital value falls. There is a real danger of the sector being overbought."

One important major caveat to the recovery is that while capital values have started to improve, rental values are still on a downward trajectory, as the demand from commercial tenants to occupy properties is weak.

It may be some time before that trend is arrested and the days of rising rents are back.

Nevertheless, financial advisers have turned positive. Hargreaves Lansdown steered its clients away from commercial property until recently; now it is encouraging them to dip their toes in.

"We've turned mildly positive - we're not piling in," says senior analyst Meera Patel. "We are saying that liquidity has started to improve, but it may be 2012 before rental growth returns."
Income is the reason to buy, she says. Headline yields of 7% to 8% should enable fund managers to deliver 5% to investors once transaction costs are accounted for. "Investors must remember that income is the prime reason to invest," she says. "Between 1993 and 2003, income accounted for 77% of the total return from commercial property."

The following years, when capital values rose sharply, can be seen as an aberration.

Gavin Haynes, managing director of IFA firm Whitechurch Securities, is also upbeat. "We certainly believe it has bottomed out," he says. "We think it is going to remain tough - we won't be seeing a V-shaped recovery - and the key when you are buying funds is to know what you are buying.

"We always look closely at the average length of tenancies and the proportion of properties that are empty."
One issue is that funds which see a strong inflow will find themselves sitting on a lot of cash that is not currently easy to invest because of a shortage of quality properties on the market, he says. That may drag down the overall return of the fund.

Banks are sitting on significant property holdings they are reluctant to sell until valuations increase, thereby causing a bottleneck, but when they do it will create opportunities for investors.

Tentative revival

Adrian Lowcock, senior investment adviser at Bestinvest, says his company turned positive on commercial property early on and snapped up some funds at unit cancellation prices to benefit from a gain when new units were created.

But he also stresses that revival in the property sector is tentative and closely tied to economic recovery: "We could still go further into recession and so there's a risk that prices would fall again.

"However, if that did happen then other asset classes will also suffer, and more so, because with corporate bonds and equities they've already had their rally."

The two main options for gaining exposure to the market are to buy individual property companies, the majority of which have reconstituted themselves as real estate investment trusts (REITs), a tax-efficient structure that is essentially exempt from corporation tax; or through property unit trusts which are a more transparent investment in property, although they sometimes hold property shares alongside actual property.

Despite the name, it should not be forgotten that REITs are quoted companies, with all the volatility that entails, and the further complication that their shares trade at a discount or a premium to their assets.

The panel opposite highlights some trusts to look out for, but bear in mind many are highly geared, operating in a sector already highly geared.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010