Building returns with wary approach

Property values plunge as the downturn continues, which raises opportunities for investors. But these assets must be actively managed to guarantee a steady income in the long term.

To assess the prospects for the real estate investment market, you have to see it within the wider economic context – the ever-worsening credit crunch that triggered a severe collapse in credit availability and consumer, business and investor confidence. It is these factors that will be a key feature in the depth and length of the recession, which is forecast by most commentators to continue into 2010.

Until mid-2007, when property values began their decline, the previous few years were characterised by increasing use of debt to boost performance and a relaxing of investment criteria and attitude to risk by investors. This culminated last year in the lowest annual total return for British commercial property – a fall of 22.1% – since accurate records began in 1971. It is more than likely that further capital decline is to come, with peak-to-trough falls likely to be in excess of 50% by the end of 2009.

Indeed, the property derivatives market has been pricing a 67% peak-to-trough fall in values. So far the Investment Property Databank (IPD) monthly index of capital values is down 42%, from June 2007 to January 2009.

The boom times saw an influx of cash from “amateur” real estate investors getting into the sector in pursuit of impressive capital growth levels. This market sentiment and the subsequent wall of equity, together with the relative ease of borrowing, were the main drivers of yield compression. Demand was driven by the belief that the capital growth would never end, rather than by the traditional real estate fundamentals of income and income growth, as it should have been.

Liquidity of property was a problem that some people did not fully understand. The future of that strategy is all too evident as this “hot” money tries to leave the market.
It could be said that the state of the market means property offers the best investment opportunity for a generation. As a result of the fallout from the credit crunch, there will be more forced sellers in the market over the next year. The key to outperformance will be
retaining a tight focus on income and active asset management.

Real estate investment should be viewed more akin to bonds, a cash flow for a contracted period but with the potential for both income and capital growth.

Over the past 28 years income has provided more than 60% of the total return from real estate (see second graph), outperforming the capital element of total return in 18 of those 28 years.

It is not about back to basics – good investment managers have always understood the importance of income. There are always opportunities to add value by proactively managing lease events such as rent reviews, lease expiries as well as landlord and tenant break options.

Property already looks cheap relative to government bonds and it will get cheaper during 2009, as property yields rise further and bond yields fall. The situation relative to equities is however less compelling, when comparing property yields with dividend yield. How sustainable dividend yields are, though, must be debatable.

Those investors who are best-placed to capitalise on the situation are those that have equity, do not need to rely on the banks and who are prepared to think differently about property. They will be able to invest in real estate opportunities that will outperform over the next three to five years. The days of short-term capital gains are gone. It is about income, strong asset management and longer-term commitments.

A word of warning: property markets are unlikely to stage a strong recovery until bank lending to commercial property returns to normal. This is unlikely to happen until the banks sort out their balance sheet problems.

As such, it does feel a good time to get into the real estate investment market. The key to the success of such a strategy will be the psychology of the investor. It is essential for investors to comprehend that income will not take care of itself. Income has to be actively managed to be effective. In this respect real estate investment is different from bonds.

The economic climate means it is more important than ever to understand and manage the risks inherent in property investment, and to actively manage the properties and tenants within property portfolios. This means looking for and recognising indicators of any trouble. It is essential to minimise property being unoccupied, not least because of the changes to empty rates legislation. Therefore it is about working with tenants to find a viable solution. Alternatively, if a tenant is going to go, managers will be in a better position to deal with it if they know as early as possible.

There is a stark contrast between today’s investment community and that of two years ago. No-one is taking risks – everyone is pricing risk and risk-plus into the equation. It will be interesting to see how long that remains the case, or if the investment psyche has shifted long term because of the seriousness of the crisis.


Property yields versus gilt yields


Consistency of income returns