Meeting at the property crossroads

Funds that have exposure to residential and commercial property will have benefited quite considerably from that allocation decision in recent years, with the performance of property significantly outpacing that of equities and bonds.

According to the Office for National Statistics, only about 6% of life offices’ and pension funds’ assets are invested in property and of that by far the bigger slice is invested in commercial property – retail, office and industrial. The percentage of institutional assets invested in residential property is negligible. Asset allocators tend to regard both types of property separately, but for how long should commercial and residential property remain two distinct areas of investment?

Investors have historically bought into these markets for different reasons. Institutions have invested in commercial property as they are seeking a total return for clients – both income and a capital gain. They are also able to add value to the properties they hold through a number of methods, including new lettings, renewing or extending leases, refurbishment or redevelopment. Homeowners primarily want simply to own a suitable house, in terms of locality and size, at an affordable price. While the concept of investment returns is important and welcome, it is not the main consideration. The buy-to-let market has so far been the domain of small investors, who are generally looking for capital growth, as rental income is usually reduced by relatively high costs of management.

Another crucial difference is the level of risk assumed by the investor. Institutions historically have been risk-averse when it comes to investing in commercial property and tend to prefer little or no gearing. This contrasts with the residential market, where investors, especially first-time buyers, have had to gear up to the hilt out of necessity. For institutional investors, this seems an astonishing risk to take, although it has admittedly produced some excellent paper returns in recent years.

Institutions have also generally shied away from the residential market because of the heavier regulation, the relatively small lot sizes, and consequential higher management input relative to commercial property.

But for all their differences, there are clear similarities between the two areas of property investment. First, some common economic factors affect the two asset classes. Generally, when the economy is doing well – when interest rates are at a favourable level, jobs are being created, consumer and business confidence is high and the economy is expanding – there is a feelgood factor, which is positive for both the residential and commercial markets. Conversely, if the economy is performing poorly, then both classes of property are less likely to do well.

These economic factors have also meant that, over the last 30 years or so, the correlation between capital growth in commercial property and owner-occupied residential property has been high. It is difficult to know if there has been a similar correlation regarding income, as information on income growth in the residential market is not so readily available. However, we can conclude that there is a significantly higher correlation between the performance of the commercial and residential property markets than many observers would have expected.

Individual investors moving from residential to commercial property has further blurred the line between the two asset classes. This is partly a result of the poor performance of equity markets in recent years, which has meant that investors have been looking elsewhere for decent returns. The low interest-rate environment has also allowed them to borrow heavily in order to gain the capital required. In addition, institutional investors are being encouraged by the Government to take more of an interest in residential property. So, are we going to see even greater crossover in the future?

Looking at residential property, an increasing number of people cannot afford to buy a house and so must rent. But interest rates are rising, making the cost of borrowing more expensive and putting pressure on buy-to-let investors. So now investors face the dilemma of whether to stay in the market, leave the asset class altogether or turn their attention elsewhere, including commercial property.

Another factor to consider is that the Government is keen to regenerate both residential and commercial property and wishes institutional investors to take a bigger interest in residential property. Recent Government efforts to attract institutional investment have so far met with limited success, however. Housing investment trusts (Hits) was one scheme that failed. Property investment funds (Pifs) are the latest Government initiative but institutions so far remain sceptical, awaiting the fine detail of the legislation. Negotiations between the parties are ongoing as to the best way for institutions to take more of a role. Only time will tell what form this takes.

With most of us owning our own houses and indirectly investing in commercial property through insurance and pension contracts as well as saving plans, about half of UK individuals’ net wealth is tied up in property. Institutional portfolios have also increased their holding in commercial property in recent years, as equities have languished and bonds become increasingly expensive. Property, therefore, is likely to remain an important part of UK investment for years to come, even without any significant switch into residential.

The prospect of the two areas of property investment merging in the future is far less likely. While there are similarities and some crossover currently exists, there are still significant barriers. The longevity of the buy-to-let market is uncertain and smaller investors may start to look elsewhere. Institutions, for their part, remain unwilling to get involved in residential property, and it may take a significant development for this to change. Therefore, we do not expect a marriage of the two asset classes in the near future.

Shows capital growth as measured by the Halifax house price index and the IPD commercial property index, rebased at 100, from December 1986 to September 2004. Source: Scottish Widows/HBOS/IPD STEWART COWE
Property research manager, Scottish Widows Investment Partnership