In mid-February, Italian fashion brand Salvatore Ferragamo paid almost £1,000 per square foot for the rental of its shop on London’s Bond Street. It is the most expensive shop rent ever seen and a sign of the buoyancy in some parts of the prime property market.
The resilience of the commercial property market in 2011 has drawn investors tentatively back to the sector after many were deterred by the boom and bust of 2007/08. But are they entering just as prime property is about to hit its peak?
Commercial appeal
Commercial property overall proved defensive in 2011, with a return of 7.8%. As Ferragamo’s shop rent demonstrates, prime property supported the market with a rise of 0.6% in the last quarter of the year and stable rents.
Secondary property continued to pull down the average figure, falling 1.9% in the final quarter, as it remained beset by the fallout from public sector cutbacks and consumer weakness. This type of property is now 42.7% below its 2007 peak.
But the overall strength of commercial property has drawn investors back into the market. Institutional investors, UK pension and insurance funds have been reinvesting because commercial property offers a source of long-term higher income with some inflation protection at a time when their options are limited.
Overseas interest
Sarah Cockburn, head of unit-linked property funds at Kames Capital, says that the market is also being supported by foreign investors such as sovereign wealth funds, plus German and French pension funds. All of these investors are risk averse, and so the majority have headed for the prime end of the market. Cockburn adds that UK pension funds may be looking at these areas as a safe haven alternative to gilts at a time when gilt yields are at all-time lows.
However, retail investors are still largely uninterested in the sector. The latest IMA statistics show that property funds saw outflows of £13m in December. Admittedly, there were other sectors that saw larger outflows, but property has been unpopular for some time.
Underlying dynamic
Alex Ross, manager of the Premier Pan European Property Fund, says that any residual over-valuation from the boom years of 2011 has been resolved: “The average property yield is over 6% on average. This compares with ten-year bonds at around 2% and very low interest rates; this compared to an average property yield in the boom years of 4.5% and a ten-year gilt yield of 4.75%. The impact of the boom and bust is now definitely out of the market.”
The overall figures mask different dynamics in the underlying sectors within the property market. Prime property, for example, is currently yielding 4.8%, while secondary property is yielding 8.3%.
There have been whisperings of a bubble, mostly in prime residential property, but this has spilled over into prime commercial property. These have tended to focus on a higher number of distressed sellers and the potential for contagion from the eurozone economic crisis.
However, for the time being, many of the conditions that have created the boom in prime commercial property remain in place. Gilt yields are low, and with another round of quantitative easing in the pipeline, likely to remain so.
The UK is still seen as a safe haven globally and, as such, demand is buoyant. Yields do not look unduly stretched compared to bond yields and, at the prime end, tenant demand is still high. As such, both Ross and Cockburn see prime property remaining relatively well-supported.
Cyclical pattern
Cockburn says: “Property goes in cycles. At the moment there is a flight to quality. The market elsewhere will improve eventually, but we are not expecting the regions to see any rental growth in the short term.”
However, there are plenty of managers willing to admit that, while prime property is unlikely to see any sharp declines, it now looks expensive.
Ainslie McLennan, property manager at Henderson, says that prime – defined as those companies that tick the boxes of good, long-term tenants and top locations – now looks highly valued. She says that there is more value in ‘core’ property, which may tick slightly fewer boxes, but has less money chasing deals. She adds: “It depends on the type of property that can be sourced. If there are distressed sellers, the price can be much better.”
Reverting to type
In both cases, McLennan believes that investors are unlikely to see much capital growth in 2012, with just the income providing the return. But this is much more akin to the traditional returns seen from commercial property, and suggests that the market has reverted to long-term type.
No-one believes it is yet the time to take a risk on bombed-out secondary property in the hope of boosting returns. Stephen Elliot, manager of the Royal London Property Fund, says that there remains very little demand for secondary property: “Secondary is likely to continue to drift out in 2012. All of these things are very much fed by economic growth. If that did come back, it would help rental growth in secondary property, but for the time being it remains very much constrained, possibly
even going backwards.”
Sarah Bate, head of research at Mayfair Capital, says: “The economic outlook is weak, with rising unemployment and continued weakness in the consumer sector. The office market outside London is also weak.”
The banks are also still offloading their unwanted property portfolios, which is generating excess supply at bombed-out prices. McLennan says: “The banks are managing their portfolios out, and many are not being sold for the amount that the banks thought they were worth. It is evidence that when there is a fall in values it tends to overshoot.”
Bricks and mortar
McLennan is also looking for opportunities in the more difficult parts of the market: “If a property can be bought for the right tenant – a John Lewis or M&S, or other expanding retailer, who will be there for the long term – yields could bounce back quite quickly,” she says.
Bate adds: “In this type of market we are looking at good old-fashioned property management – property that will always have a tenant, that is in the right place and has the right specification.”
She says that this involves “seeing the whites of their eyes” for tenants, knowing their plans for the business and understanding the potential for vacancy rates.
In terms of the perennial divide between property equity and bricks and mortar funds, the latter had the edge in 2011, as property equities fell along with the wider equity market. Particularly weak were those exposed to Europe. Nevertheless, looking into 2012, many property equities are now trading at relatively wide discounts to net asset value.
Prime property is highly valued, but well supported. This means the majority of the total return in 2012 is likely to come from income.
Managers are trying to boost returns with selective investment in under-managed core or even secondary property but all believe that a wholesale movement into bombed-out secondary property is simply too risky in the current environment.
In spite of some eye-catching deals, the commercial property market has – for the most part – returned to business
as usual.
