Solid yields compensate for real estate wobbles

The highly cyclical commercial property market fell by 42-44 per cent from its peak in 2007 to its trough in 2009, according to the IPD All Property index.

Having then improved, for the last four to five months it has turned negative again. The latest Investment Property Forum consensus quarterly forecast predicts that capital values will fall by 4.6 per cent in 2012, with a total return of plus 1.6 per cent, and returns will then be flat for five years. However, back in November 2011 the Forum was forecasting a rise of 4.5 per cent so views have turned bearish very quickly.

Nonetheless, the asset class remains attractive for its yield, currently around 6.2 per cent, according to the IPD All Property index, with the focus on central London offices in the UK and other areas linked to the growth of the global economy.

“There is a two-tier market and prime quality property with good leases and tenants, such as offices and malls, are still in demand, particularly in central London,” says Guy Barnard, fund manager at Henderson Horizon global property fund.

“International interest shows no signs of abating. Property valued at £2bn (€2.4bn) was sold in London in the final quarter of last year – which is in line or even ahead of what we have been anticipating. Interest is strong from Malaysia and sovereign wealth funds, and even from Southern Europe as some investors are keen to move their money out of the region,” explains Mr Barnard.

“Jones Lang LaSalle and GM Real Estate both believe that the wave of equity capital will continue, dispelling any doubts we may have harboured at the end of last year,” he explains. “The volume of deals done this year is better than last, while little supply is coming on.”

The persistent weakness of sterling supports sectors such as tourism, retail and central offices in the City, whose tenants can suck in business from abroad. As inflation drifts back towards 2 per cent, any further shock could force the government into another round of quantitative easing, perpetuating further weakness in the currency.

In retail, prime shopping malls are preferred over the high street as malls enjoy higher footfall and attract international retailers looking to expand, such as Unico, Apple and Abercrombie.

LAND OF THE GIANTS

The current market in London also favours the giants, such as Land Securities, Hammerson and Great Portland, which have excellent access to debt and should be able to use their relative strength to take advantage of their position. British Land and Land Securities are building large and speculative City offices in the Cheese Grater, as the office block under construction at 122 Leadenhall Street is informally known, and at 20 Fenchurch Street, for example.

The giants are also more confident dealing in the murky world of secondary markets. British Land, for example, has completed a number of non-core deals such as a shopping centre in Barnstaple and Virgin Active gyms, a deal yielding 6.5-7 per cent from day one.

While arguably prime property has peaked, that does not necessarily mean activity should be switched to the secondary markets. “Property still looks relatively attractive in terms of yield but it is richly valued,” says John Mancuso, director, real estate, Emea, at Russells.

“There has been a big focus on core in prime and major urban areas over the past few years driven by investors’ desire for a steady income stream. All this capital flow to that part of the market has made the market recover so we are cautious and think it may be overpriced and have been telling clients to be careful. There will be opportunities in secondary markets relatively soon, but not yet, although it is an interesting place to look because of the wide disparity between prime and secondary,” he says.

“Yields in many core markets are back to where they were pre-crisis but as interest rates are low, on a spread basis the asset class is still looking attractive,” adds Mr Mancuso.

“The question is how long government bond yields will stay low, and having come in considerably in the past few years, they are more likely to expand.”

Distressed situations, or more broadly, deleveraging situations, are the talking point today. “Some recent sales have involved assets at discounts to their replacement cost which is usually a buy sign,” says Mr Mancusco.

“In terms of return, value added and opportunistic (styles) can pay 300-500 bspts over core, and this is attractive because managers don’t need to take same level of risk they took historically. In this part of the market the key is to find managers who are targeting good niches and have experience of investing in distressed situations such as in financial engineering and skill with dealing with overleveraged properties; relationships are also very important to access distressed deals,” he adds.

Fund managers like companies that are exploiting their access to capital, such as Simon Property Group, which has used its cost of capital to acquire a controlling stake in French retail landlord Klépierre SA. Many of Klépierre’s properties are shopping centres anchored by huge grocery stores, which are more resistant to downturns than malls. Simon also has a track record at boosting the value of properties through marketing and altering the tenant mix.

FINDING A NICHE

Another trend is the emergence of residential niches as institutional asset classes, where opportunities may be overlooked because most institutions have not covered the residential sector other than buy-to-let or quoted housebuilders, and residential typically yields 3-5 per cent in comparison with 5-7 per cent yielded by commercial assets.

Reits (real estate investment trusts) that focus on apartment blocks are an attractive niche in the US, particularly those that access growing West Coast apartment markets such as San Fransisco, Oakland, Los Angeles, Santa Ana, and San Jose. These markets are still attractively priced as supply is constrained and growing by less than 1 per cent per year. Prices in Los Angeles and Seattle are 9.7 per cent and 7.5 per cent below their 1990 averages respectively, for example.

Student accommodation in the US and UK markets is another enduring niche as the advantages of a university education are driven home in difficult economic times. Peter Zabierek, senior portfolio manager for Urdang, the real estate investment specialist for BNY Mellon, points out that London is an educational magnet and home to some 80,000 overseas students.

Despite last year’s 7.4 per cent drop in university applications, there were still 160,000 more applicants than places, and Net Operating Income at the typical student hall of residence is up 3-4 per cent. The sector is close to 100 per cent occupied, with average starting yields around 6.6 per cent, and private equity interest is growing.

REMOVING RESTRICTIONS

The conversion of commercial property into housing has already been seen in London’s West End and in Vauxhall, but will become easier following the government’s proposals to remove restrictions and ease the difficulties associated with requests for change of use which are subject to planning permission with all the costs, delay and uncertainty that entails.

Ultimately, the commercial market that will benefit even more as some of the 7 per cent overhang in office space will be absorbed. “Residential prices have outpaced commercial property over the past 50 years, yet planning restrictions mean there are

persistently higher levels of vacancies in commercial than residential property,” says Henry Lancaster, senior investment analyst at Coutts.

“If conversions to housing were to absorb surplus commercial property, then the underperformance of commercial property could reverse,” he explains. Commercial rents currently tend to rise in line with inflation but if instead real growth rose in line with the broader economy the theoretical value of commercial property could rise by up to 40 per cent.

However, the loosening of regulations covers only industrial and office property, not retail, and the conversion of existing buildings, and it may not be until the economic cycle turns that developers can capitalise on the full potential.

Debate about equity exposure versus direct investment rumbles on. Urdang’s Mr Zabierek says that over the last cycle 1990-2007/8 listed real estate outperformed core despite its supposed liquidity.

“Listed real estate is also less correlated with other stocks than is generally believed,” says Mr Zabierek.

“Research by Stephen Lee at the Cass Business School, ‘The Big Picture’, shows that over the short term the correlation of Reits to large cap stocks is 50 per cent, but the correlation heads down as the holding period increases.”

Steve Buller, fund manager of Fidelity’s Global Property Fund, shares this view, adding that property stock returns are half driven by fundamental factors such as occupancy, supply and demand and half driven by the capital side of businesses such as access and capital flows into the asset class but he is currently minded to spend more time examining the capital side.

“In the crisis, it was all about the capital side,” says Mr Buller.

Potential for income attracts investors

Few advisers are bullish about the future for property returns per se but property yields are attractive in the context of a persistently low interest rate environment, and the asset class is still seen as a diversifier. “Investors are still looking for yield to compensate for the lack of purchasing power they see on their cash,” says Henry Lancaster, senior investment analyst at Coutts.

“If they stick to prime then there is reasonable security, but any external shock could push the UK into recession.” He likes funds with long track records such as Scottish Widows and M&G, saying this is the kind of market where experience counts.

Arguably, some life offices operating an open wrapper have over-large holdings in cash, although some of that will be in property stocks, synthetics or indices. Closed and unregulated collectives can work harder and investors know in detail all the buildings in the fund and their covenant strength.

Delyth Richards, head of fund research at Kleinwort Benson, suggests listed infrastructure as an alternative for income linked to the retail prices index. The sector has grown rapidly since HICL Infrastructure launched in 2006, which recently raised an additional £250m (E300m) from investors. Others include Bilfinger Berger Global Infrastructure, International Public Partnerships, John Laing Infrastructure and 3i Infrastructure. All trade at premiums, but continuing fund raising offers investors attractive entry points.

Ms Richards says she is attracted to the asset class’ income merits and the government’s stance on privatising the sector which is unlikely to change. They also look at mezzanine finance in this sector with its attractive up front and roll up fees and high coupons.

Jeff Steadman, SIPP and SSAS business development manager from Xafinity, makes the case that putting commercial property into a SIPP (self-invested personal pension) can be attractive if a small employer has cash flow restraints in the current tight lending environment. Xafinity saw a 35 per cent increase in commercial property investments in SIPPs in 2011. These SMEs are typically small or family firms such as dentists or hairdressers, with between two and 30 employees.

Once a property has been put in a SIPP, any future sale will be free of Capital Gains Tax around which there is much uncertainty, while now is not a bad time to buy property and any future growth will be protected, says Mr Steadman.

He has one client who put three car parking spaces in Edinburgh worth £90,000 into his SIPP. Farmers are also putting land cited on the edge of towns into SIPPs in the belief that loosening planning permission restrictions could escalate the value of that land at some future point.

VIEW FROM MORNINGSTAR

Winners and losers

Real estate prices have been rising for years all around the world and it is not surprising therefore to see property funds with strong returns over the past 12 months. It is important to remember that the funds in the Morningstar Property – Indirect Global category do not actually invest in physical real estate, but in listed companies that own real estate or are active in related sectors (such as building materials).

While stockmarkets have had ups and downs during the period, many property funds increased their returns by more than 10 per cent with some above 15 per cent. This is the case with ING Global Real Estate Fund, which over the past 10 years has delivered 5.40 per cent per year, very attractive compared to the average return of MSCI Europe, which delivered -1.76 per cent per year over the same period.

The ING Global Real Estate fund takes a concentrated approach with 35 stocks in its portfolio. Each stock in the fund is carefully selected by the team to ensure that they do not have two stocks with a similar profile, which probably explains the low volatility of the fund, which, despite its high level of stock concentration, is below average in the category. In addition, the fund is geographically very diversified.

Some funds delivered poor returns over the last 12 months, including the Morgan Stanley Global Property Fund, which returned -5.60 per cent. Although less than 25 per cent of the portfolio is invested in the US, the fund failed to stay in black, demonstrating the difficulty of managing a global portfolio while maintaining an accurate perception of the strengths and weaknesses of companies in local markets.

Frederic Lorenzini, director of research, Morningstar France