Henderson New Star's Ainslie McLennan says the turnaround in commercial property reflects the shift in investor sentiment.
What a difference a year makes. It was not so long ago investors were shunning commercial property, yet in the final quarter of 2009 it was the best-selling sector in terms of net sales, according to the IMA. This turnaround reflects the shift in investor sentiment towards the asset class as fears of financial Armageddon subside and investors seek to take advantage of the sector’s relatively attractive valuations and high income levels.
Recordings
The Investment Property Databank, which compiles data on the sector, reported UK commercial property prices began to recover in the summer of last year and in December 2009 they rose by 3% – the strongest rise ever recorded for a single month. While credit and equity markets have rallied substantially during 2009, however, the commercial property markets have only just picked themselves up from their lows. In the UK, average prices actually declined 5.6% for the full year, although they had climbed 8.8% from their July 2009 trough. By comparison, the FTSE 100 index of leading UK shares had risen 54% by the end of the year from its March 2009 low.
Despite the recent recovery, average prices remain 39% below their 2007 peak. More importantly, commercial property continues to retain a high yield relative to most other asset classes. At the end of 2009 the initial yield on the UK IPD All-Property Index was 7%. This looks attractive when weighed against a yield of 4.1% on a 10-year UK government bond and the Bank of England’s bank rate of 0.5% – the benchmark rate for many savings accounts.
It is small wonder, therefore, that retail investors poured some £1.3 bn of money into property funds in the final quarter of 2009. The net inflows mean retail funds are on the lookout for acquisitions, joining a growing group of opportunistic investors, institutions and overseas buyers seeking to take advantage of current valuations.
Overseas buyers
Overseas buyers have been a presence in the market for much of the last two years. The UK’s landlord-friendly, established property market coupled with lower prices and a weak pound has made it structurally attractive and inexpensive. Domestic investor numbers grew as prices reached a low last summer, with interest building as it became clear the sector had passed through the worst.
Although investor demand for UK commercial property has grown, supply has not. There are two reasons for this: one fundamental, the other behavioural. At the fundamental level, supply has shrunk because we are at a stage in the development pipeline where few new properties are coming on to the market.
To some extent this owes its origin to the credit crisis: unable to gain finance in recent years many construction projects have simply been shelved. Added to this is the fact many existing holders of property no longer need to sell. Listed property companies have spent the last two years rebalancing their portfolios, paying back debt and tapping the equity markets for capital whilst net inflows into retail funds mean these funds are cash rich.
Reluctance to sell
At the behavioural level, in a rising market holders of an asset are reluctant to sell for fear of missing out on further gains. Banks, which had become de facto landlords because of delinquent property loans, fall into this category. They are disinclined to part with assets that are rising in value (or where losses are narrowing). Similarly, they are prepared to be lenient with over-extended borrowers. Why crystallise losses for both parties when the passage of time and rising asset prices might erase the problem?
Rising investment demand may help to lift prices but the occupier market needs to show improvement for the recovery to remain firm. It is, after all, the tenants who pay the rent that ultimately makes a building valuable. On that score, there are some welcome positive indicators. The Royal Institution of Chartered Surveyors reported occupier demand moved higher for the second consecutive quarter at the end of 2009. They report new occupier enquiries rose across the three principal sectors of office, retail and industrial although effective demand was strongest in offices and industrial, with retail still lagging outside the South East.
The office sector has been the most resurgent. The steep fall in headline rents that characterised the sector in 2008 and 2009 appears to be drawing to a close. In the final quarter of 2009 prime rents in the City of London actually rose to £45 from £42.50 in the third quarter according to GVA Grimley, while the vacancy rate fell to 9.7%, down from a high of 10% in the second quarter. The industrial sector has been surprisingly buoyant and may be responding positively to the marked decline in sterling over the past two years making UK production more competitive. The CIPS manufacturing survey for January 2010 reported a rise to 56.7, the highest level in 15 years, indicating expansion. This is following through to less available floorspace and landlords offering fewer inducements to tenants to take up space.
With the economy seemingly stabilising the outlook for rents should start to improve, although the UK’s lacklustre escape from recession – a mere 0.1% growth in the final quarter of 2009 – cautions that the economic recovery remains fragile. The headwinds of a general election and potential fiscal and monetary tightening on the horizon mean we expect price rises to moderate in 2010. This would be no bad thing. Property works best when it is viewed as an income-producing asset rather than an instrument of speculative gain. With property still in the early stages of recovery, however, a diverse portfolio of properties on strong leases and with quality tenants should offer a decent income and the potential for long-term capital gain.
Ainslie McLennan, co-manager of the New Star UK Property Unit Trust at Henderson New Star
