A global approach to commercial property is needed
To say that the UK commercial property market has fluctuated widely over recent years would be something of an understatement. Back in the middle of 2006, annual returns exceeded 20 per cent before plummeting to -26.5 per cent at the market trough in May 2009. But capital values subsequently rose sharply and annual total returns peaked at over 24 per cent in July 2010.
Since then, performance has moderated, with returns running at around 3 per cent a year at the end of October 2012, as income more than off-sets modest falls in capital values. But what can investors expect now?
Property market pessimists point to a weak UK economy, which entered a double-dip recession earlier this year. Tenant demand – certainly outside London – is at best patchy. Shop vacancies have risen in many small towns as consumer spending weakens and the draw of large, dominant shopping centres, retail warehouse parks and the internet take their toll on traditional high streets.
The property market has also become highly polarised. Relatively strong demand for investment property in London has flattered overall market indices and masks weak demand elsewhere. And then there is the overhang of debt: the annual survey of UK commercial property lending by De Montfort University suggests over £150bn of loans are due to mature by the end of 2016. There is a looming funding shortfall as many commercial lenders scale back activities due to risk aversion and more stringent regulatory capital requirements.
Property market optimists, on the other hand, point to the high level of yields relative to fixed income markets. The gap between property and five-year government bonds yields currently stands at around 570 basis points. A wide margin has also recently emerged between property yields and the yield on some corporate bonds: at around 360 basis points, this is the widest margin for at least a decade.
Yes, tenant market conditions are generally weak, but optimists say this is more than accounted for in the price. Unlike some previous property cycles, the UK is not, in general, facing significant over-supply due to excess development, partly because bank finance is limited. Finally, some lease contracts are linked to inflation, providing a degree of protection in an environment of low economic growth but inflation above the UK’s Monetary Policy Committee’s target.
Despite a weak rental outlook, we believe prospective UK total returns imply a premium over gilts significantly higher the historic average. But this largely reflects historically low yields on government debt and the effects of quantitative easing. On an absolute basis, future returns look less appealing: we estimate 5-year nominal performance to average between 5 and 7 per cent a year, implying real returns (after expected inflation) at or slightly below the long-run average. Costs and fees will reduce returns further. As you will be aware, an investment in the property market involves risks to the value of both capital and income and investors may not get back the amount originally invested.
But overall, we maintain the cautious stance towards direct property in the UK. Listed property securities – or equities in many countries offer better long term value, largely because, outside the US, they generally trade at significant discounts to net asset values. Despite strong recent performance – the main global listed property index rose by over 17 per cent in sterling terms over the 12 months to the end of October 2012 – we have a bias towards global listed property over UK direct. Certain direct property markets, such as Australia, also offer superior returns relative to the UK. In short, we believe a global (rather than domestic) approach to property offers advantages for both risk and return.
Guy Morrell is manager of the HSBC Open Global Property fund
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