How solid are property’s foundations?

Commercial property investors have been enjoying more than a decade of positive annual returns. But how sturdy is the sector now, and is the current boom about to turn to bust?

According to the Investment Property Databank, 2004 was one of the best years for commercial property investors in an unbroken series of 12 positive years for the sector. Overall, commercial property produced 18% last year, with the retail sector strongest (up 21%) and offices the weakest, albeit with an attractive 14% contribution. Returns into 2005 have continued to be attractive.

It is understandable that commercial property has returned to favour, given the long-term consistency of returns and an overall disappointing performance from equities.

Arguments for including the asset class in an overall allocation are that it can provide a stable income flow as well as the potential for capital growth, and it is a good diversifier, lowly correlated with other asset classes. These have held sway within the institutional investment sphere, where pension funds have increased weightings to the sector considerably over the past few years, boosted by relative outperformance as well as cashflows. The returns have also begun to catch the attention of retail investors, and several new funds have been launched to feed the current appetite for all things property. But is this a classic top-of-the-market phenomenon, much as the technology sector saw five years ago?

A key issue is whether the expectation of a low correlation of returns with equities and bonds is correct or whether it is instead a reflection of valuation practices.

A feature of the property market is that there are many more valuations than actual transactions. In fact, many properties that are confidently valued each quarter do not change hands for many years and sometimes never trade. Instead, the “value” is based on assumptions and estimates. What is the current rental and will it grow? What is the correct yield? What is the risk of default, the strength of covenant, and the chance of void and of re-letting? All of these factors and others are considered in a valuation and a best estimate is made.

If we consider the price trends of the quoted property sector we can see that it is actually quite closely correlated with the overall equity market. The question then arises of whether the valuation of property companies can be so far out of line with the values placed on the sector. Clearly logic – and the ability to break up portfolios – dictates that they cannot, and so what we observe when we compare the apparent difference of returns between equities and property is not a significantly different pattern of returns, but rather a reflection of the significant difference in pricing regime. Just as with-profits funds with their smoothing mechanism were for a time considered lower-risk than managed portfolios with similar constituents, so commercial property – a prime real asset – is somehow thought to be able to resist the trends of the real economy that take place within its walls.

There is another problem, this time related to supply. When the market is depressed, the incentive to build new property is slight, exacerbating the shortage when the upturn begins. As prices rise new supply enters the market, but with a lag – planning permission and construction take time. This means that at the top of the market, when prices are full and buyers turning away, new property continues to arrive on the market, and this extra supply helps the downswing. Property prices can fall and in the past have proved to be vulnerable after sharp upward moves. In 1974 returns were negative by nearly 30% and in 1990, despite the contribution from rental income, returns were minus 15%.

So is it time for a commercial property bust? This seems unlikely in the short term, given continuing strong investment demand. However, there are signs that one of the main long-term supports for the market may be starting to crumble. Over the second quarter of the year as the British economy cooled there was a sharp fall in demand for commercial space. This was felt particularly in the depressed retail sector. If this trend continues and property companies find it increasingly difficult to attract tenants, rental yields will inevitably fall. Of course, prices do not have to plunge for the sector to lose position relative to equities, bonds or cash.

There are other important considerations: liquidity, costs and potential returns. The impact of liquidity is obvious from the price gains of the past few years. Huge cashflows into a market of poor supply elasticity have forced prices higher. What happens when flows begin to fall off? This is particularly important in an environment where sector advocates say exposure should be 10, 15 or even 20 years. Closed pension fund liabilities are shortening and for many, long-term multi-year commitments are less and less appropriate. Private client requirements are even more prone to the vagaries of fad and fashion. Investors need to be comfortable that the sector is robust enough to rise above a different and far less supportive cashflow environment.

This brings us to costs and potential returns. Expectations for returns from commercial property in the years ahead are clustered around 8%. Reduce this by management fees and dealing charges and the net expectation is nearer to cash than to equities. Also, property is not cheap to buy. Those who blanch at 0.5% stamp duty on equities will swoon at the 4% on real estate. Round-trip costs of 7-8% are a huge burden to place on return expectations. After an extended period of positive returns it may be time for contrarian investors to consider policy for the period ahead.

Finally, we tend to talk about property as if we can hold it all, when in reality we experience only the subset in our portfolio. And just as there can be a huge variation in returns from individual shares, so there can be a difference in returns from properties. True diversification within the sector has traditionally required huge funds, but this is an area where derivative products will surely take over, designed to give index returns from the asset class without the cumbersome and costly process of buying into bricks and mortar.