I wrote recently about my growing interest in commercial property [1]. I consider property a core holding [2] – if bought at the right price.
Commercial property grew to wildly inflated prices during the boom, and investors who followed performance to load up at the peak have seen their property investments crash.
But that was then, and this is now.
In this post I’ll give five good reasons why now could be the time to increase exposure to commercial property.
1. Investors have spurned commercial property
Like an abandoned eyesore blotting the High Street, the commercial property sector is unloved and unwanted.
But as every good developer knows, the time to buy real estate is when the masses wouldn’t touch it with a scaffolding pole.
One easy way to get a measure of the British commercial property market is through iShares’ IUKP tracker.
This ETF has holdings in dozens of listed property companies, although it’s dominated by Land Securities and British Land, who in turn dominate the sector.
At the worst point since January 2007, IUKP had declined 80%. Even after a near-50% bounce, it’s still down 72%.
Property was very overvalued, but such a spectacular fall represents an awful lot of froth being blown off the market.
Non-listed funds have done badly, too. As a result, many funds stopped investors withdrawing their money, and some managers have gone bust or been taken over.
It’s very hard to get a feel for fair value, given all the other uncertainties. Rents are declining as voids (empty properties) increase – and rental income ultimately determines the value of commercial property.
Certainly there are commentators who believe both rents and values will decline further from here.
There’s also the argument that a 20-year borrowing binge is still being unwound, which will further impact the sector.
On the other hand, people always say this sort of thing at the bottom of the market, and an 80% decline is not to be sniffed at.
Unless you believe in Economic Armageddon – which I think is now off the cards – then I think now is as good a time as any to start building up a holding in commercial property.
Prices of listed REITs have already bounced 50%. Waiting for cheaper prices could be a mistake.
2. New institutional buyers are sniffing about
Evidence of value is the emergence of various bottom-fishing funds and private equity vehicles looking to invest in the property sector on the cheap.
Business Week revealed [3] yesterday that Blackstone, the private equity giant, is looking to raise $2 billion for a new special situations property fund.
It’s just one of a string of such funds to emerge in recent months.
Admittedly, Blackstone will target real estate debt rather than equity, as that’s where the dislocation from the credit crunch has been most severe.
But plenty of others see the relative recovery of the financial markets since last year as a reason to buy property, as Business Week reported [3]:
David Tye, the chairman of Rugby Estates, said […] “The buying of property assets is now looking very attractive.”
The sector’s most lauded recent fundraising example was Max Property Group, the brainchild of industry giant Nick Leslau. Max raised £220m through a listing on AIM last month.
It was the first flotation of 2009. The value of the company surged 30 per cent on its first day of trading.
Investors Chronicle [4] has also covered the flood of emerging property funds, writing only today that:
With signs of value returning to the sector and the potential for the big Reits to pull off transformational deals we’re cautiously positive on the sector as a whole.
3. Yields have improved
There are two yields to consider with property investments.
- The rental yield, which is a measure of the annual rental income relative to the price paid for the building. (Annual rent divided by purchase price).
- The valuation yield, which is a measure of the income derived relative to the current valuation of those assets. (Annual rent divided by the current valuation).
Rental yields have been declining, as the recession causes tenants to go bust or delay payments, leading to higher voids.
How far they’ve fallen depends on what kind of commercial property you’re looking at. Office rents have fallen hardest, but retail rents have done worse recently.
But neither have yet been insanely severe for higher quality commercial property.
Land Securities, for instance, saw like-for-like voids increase from 3.5% to 4.6% over the past 12 months. A big rise, but not massive in absolute terms.
Admittedly, it hasn’t taken much to upset the balance sheets of heavily indebted property companies, which is why some such as Brixton have nearly gone bust and most have undertaken rights issues.
But in many cases the rights issues are a function of declining values relative to debts, which have necessitated the re-footing of company finances. Falling income has been a secondary factor.
Looking at Land Securities again, revenue profit increased 10% (partly due to lower interest costs) in the last financial year, and revenues from its London and retail portfolio grew. Yet the valuation of its assets fell 34% over the year.
As a result of price falls, the valuation yields have risen on REITS like Land Securities.
Land Securities has cut its dividend and it is forecast to halve it again in the year to 2010, but with a current dividend yield of 5.9%, new buyers are getting a higher yield than investors have seen for many years.
Similarly, the IUKP ETF is yielding over 7%, which is a very big premium over the risk-free rate. And many listed property trusts are on double digit yields.
I don’t want to overstate the case – this has been a torrid time for commercial property, and it’s probably going to get worse. Property was overvalued, and prices had to come down.
But I do think investors buying at today’s valuations will enjoy a much better return than those who were sucked in when property was yielding just 3%.
The risks are clear, but so is the opportunity.
4. The UK recession could be ending
Some say the economy already has turned positive. After such a torrid couple of years, absent a Depression it really had to.
Having finally grasped that the UK economy was in trouble after years of rosy-eyed reporting, the mainstream media hasn’t said much about this. Doom, doom, doom is still selling newspapers today.
But plenty of green shoots are emerging. To cover them would require another post; suffice to say I think you want to buy commercial property before the consensus turns universally rosy.
A strengthening economy will provide new challenges for the sector, in the form of rising interest rates.
But valuations are so low and the lack of finance has been so acute during the credit crunch, I think the positives of even a modest return to growth and lending would greatly outweigh that negative.
5. Commercial property is a hedge against inflation
Here’s my final and perhaps best reason to buy commercial property right now.
At its heart, this asset class [5] is about investing in real assets by taking on lots of debt, and enjoying rental income and capital growth.
As such, it could prove valuable should inflation takes off again because low interest rates and reflation schemes like quantitative easing [6] overcook the economy.
Commercial property is seen as a halfway house between the growth potential of equities and the fixed income of bonds.
But right now, I think the inflation risk makes most bonds look very unattractive, particularly Government bonds.
The potential for commercial property prices to rise while debt is inflated away due to an inflation spike increases its attractiveness to me.
In contrast, the fixed income and value of bonds could prove very vulnerable in such circumstances.
True, rising interest rates in the face of inflation will make life harder for commercial property companies.
But the Government and the Bank of England has a clear incentive to let inflation get slightly ahead of itself, given the debt we’re in personally and as a country. You can already see that with rates at an all-time low of 0.5% despite inflation being above target.
Nobody has ever predicted inflation or interest rates with any consistency.
But taken with the other four factors I’ve listed above, I consider inflation risk is a final good reason to invest in commercial property.
Conclusion
Commercial property has suffered huge price falls, way ahead of the actual decline in rents. Investors’ fears have to an extent been very valid, and rents are sure to come under further pressure.
But price declines have been extreme, and in the medium-term the investment case for commercial property [2] still stands.
If you’re not sure how much commercial property you should hold, you might look at my post about David Swensen’s Ivy League portfolio [7].
Ultimately though, it’s make your own mind up time.
For my part, I’m buying commercial propert [1]y in dribs and drabs. I currently hold about 5% commercial property with an eventual aim of around 10%.