The property market, after a difficult couple of years, has seen a marked recovery over the past 12 months.
Capital values have risen by 15% and the asset class has returned to favour with investors, while data from the Investment Management Association shows net inflows of more than £3bn over the past year to end of June.
Property has outperformed both equities and gilts over the past 12 months according to Investment Property Databank (IPD) figures, but past performance is not necessarily indicative of future returns as investors are well aware. The UK Chancellor George Osborne has predicted a “choppy” recovery in the wider economy while others warn of a “double dip” if policy is tightened too abruptly. So, might property be about to enter a more challenging phase?
Reasons to be cautious
There are reasons to be cautious. Investors are concerned about the impact of fiscal tightening and continued low availability of credit on consumer spending and business growth and this has implications property. Businesses, whether in the retail, office or industrial sectors, will only take more space if they see a period of sustainable growth with rising revenue, adequate liquidity and higher profits and a choppy recovery could keep them on the sidelines. A double dip, with rising unemployment and business failures would affect the occupational market more severely.
Additionally, during the boom years, the banks lent heavily to property and these loans need to be repaid. De Montfort University has estimated that £228bn of property debt is outstanding with £50bn in breach or default. As banks work through these problem loans and reduce their exposure to the sector – properties may need to be sold and this increase in supply could affect pricing. Although the property market remains in recovery mode, and capital values are still rising, the pace is slowing – in July 2010 monthly growth was a miserly 0.2%
Property nevertheless has factors working in its favour. The income return from property is more than 7% pa, which is very attractive in comparison with other asset classes. At the end of July, both gilt and equity (all share) yields were below 4% while the rate on cash is minimal.
Nor is this a temporary phenomenon; the income return on property has averaged 6.7% over the past 10 years. Again, the past may not reflect the future, but latest consensus forecasts from the respected Investment Property Forum point to an income return of around 7% for the five years to 2014. Property saw a sharp re-adjustment in values during the market downturn, which has only partially been reversed over the past year and values remain 36% below their peak level, providing a still attractive entry point for new investors.
Additionally, property looks well positioned when compared against the risk-free rate and property’s historic risk premium. Property yields have moved in sharply over the past year but the initial yield of 6.5% is still more than 150bps above “fair value” calculated on this basis. Today’s risk premium may be higher than in the past and gilts are at exceptionally low yields so the prudent investor might wish to allow an additional margin to account for this. On current evidence, and with consensus estimates pointing to only a modest rise in gilt yields over the coming year, property does not appear over-priced at present.
Property may also be of interest to investors seeking diversification from other asset classes. Direct property has displayed a low correlation with equities of 0.4% and -0.2% against gilts since 1988 according to IPD data. Although property has not been immune from market turmoil, direct property has displayed a lower volatility in total returns over time than the equity market and the property share market. This may in part reflect less frequent valuations in this market but for investors looking for greater stability in returns, it is still a consideration worth bearing in mind.
A wise choice
On these grounds, property may still be a wise choice for investors wanting a high and stable income return and for those seeking to enter the market at attractive pricing levels.
That said, if the economy is set to be “choppy” – should investors hold back until the recovery is on a firmer footing? That view has its adherents across all asset classes but it can pose a particular problem for property investors. Property is different from other assets in that each individual property is unique. Every property has a different risk profile – tenant mix, lease length, and void rates will vary. Building quality and re-letting potential will also be different across each property and of course location is specific to that particular property.
This is a matter of some importance to investors. Data from CBRE showed that in the year to June, prime property had recorded a 26% rise in value while secondary stock had seen no change in value at all. Unfortunately, prime stock that “ticks all the boxes” is in short supply so investors who believe property will deliver performance in the long term may need to buy as and when a suitable property is marketed and be prepared to hold the asset to achieve performance.
Investors may find a similar situation exists when choosing a suitable fund. Fund launches are not evenly spaced across cycles and getting in on the ground floor of a well-run fund at launch may prove prudent for long-term investors rather than waiting and paying a premium as the market gains traction.
Downside protection
Finally, although there is much talk of a double dip in the economy, consensus forecasts are for muted GDP growth gradually building to growth rates of 2% pa or more. None of the forecasters monitored by Consensus Economics is predicting recession in 2010 or 2011. So while the economic outlook is not wildly exciting, it is a far cry from the 4.9% fall in GDP recorded in 2009 and this may provide some protection on the downside for property.
UK commercial property does have significant attractions for investors even in a difficult economic environment. We expect performance to slow from the heady rates seen over the past year and investors seeking large short-term capital gains may be disappointed. For those investors looking for long-term income with the prospect of some capital uplifts over time, property investment may still represent a sound option.
Julian Smith, Fund Director, F&C UK Property Fund
