By ROBERT HARLEY 09/02/2007
After three spectacular years, investor appetite for UK commercial unsurprisingly remains high. However, the sector looks to be running out of steam. The annual returns of around 18% experienced over the last three years are expected to fall into single digits moving forwards.
| "These high returns have been driven primarily by yield compression." |
These high returns have been driven primarily by yield compression (i.e. rising property prices), as the differential between property yields and gilts have narrowed from about 3% in 2003 to approximately 0.25% today. Can this go any further? Possibly. There have been times in the past when property has yielded less than fixed rate gilts and property still provides a comfortable premium over inflation linked gilts, which are often used as an alternative proxy (given rental rates tend to adjust with inflation).
However, the consensus view is that the yield compression story has largely run its course. If this is the case then investors will have to increasingly rely on property yields (about 4.5%) and rental growth (broadly in line with the CPI at 2.5%) to drive returns, resulting in a total return of 7% p.a. before fund expenses.
On a more positive note, the supply/demand equation looks balanced and speculative development remains relatively low. No-one is anticipating a crash as happened in the early 1990s.
As the rising tide effect from yield compression lessens, we are also likely to see a greater spread of returns across different property sectors. The consensus view is that offices (London in particular), offer the best medium term rental growth prospects while the retail sector (which accounts for almost 50% of the IPD benchmark) will struggle. We expect the emphasis to switch to safer prime assets, i.e. quality properties let to blue chip clients on longer leases.
But if returns from direct UK commercial property decelerate, investors might ask what their options are within this asset class to maintain some performance momentum, after all property is a non-transferable asset whose returns tend to reflect local market conditions as much as the broader economic climate.
| "An alternative is to consider funds that invest in property companies (or REITs)..." |
An alternative is to consider funds that invest in property companies (or REITs) such as Land Securities or British Land, or their European or global equivalents. However, there are fundamental differences to bricks & mortar; property companies tend to carry debt and generally exhibit a higher level of correlation to stockmarkets.
The funds available tend to have different areas of focus. Some are regional (e.g. TR Property Plc – UK & Europe) while others are global in their outlook (e.g. Schroder Global Property Securities or Fidelity Global Property). Many of these funds focus on overall returns rather than income, but Franklin Global REIT is an exception and it also hedges foreign currency exposure back into sterling. New Star has also announced the launch of a global bricks & mortar fund later this year.
We believe that given its lower correlation characteristics with other asset classes, bricks and mortar property remains an integral part of asset allocation. However, with yield compression in the UK looking to have run its course, investors should moderate their return expectations and perhaps seek better rewarded opportunities abroad, whilst taking care to monitor exchange rate risk.