This downward trend has now continued into 2009 with capital values reducing by around 40 per cent from their peak.
It is widely expected that commercial property will continue to fall, perhaps even a further 5 per cent to 10 per cent, before finally levelling out. This will continue to have an impact on pension schemes and the investment options available. However, trustees should not ignore the potential of commercial property as a suitable investment option for the future.
Many property fund managers are predicting that 2009 as a whole will be a further negative year for property funds. It is expected that the market will then begin to recover in 2010 to produce either a neutral or even a small positive return, with a return to a longer-term tend of positive returns of 7 to 8 per cent a year thereafter.
In the early part of this decade, property was the top-performing asset class in comparison to equities, gilts and cash.
Despite the decline in values seen over the last couple of years, many believe that property values will soon begin to increase once more. However, returns for pension schemes and other investors are likely to be more modest than double-digit returns previously achieved.
Looking ahead, I anticipate that rents in the short term will be stable or even downward as we enter a period of deflation. In the longer term, rents will continue to increase broadly in line with inflation.
If allowances are made for depreciation and the expenditure required to maintain property, long-term net income growth of between 1 per cent and 1.5 per cent still looks likely.
With income returns of 6 per cent a year, this will result in a long-term total return of something in the order of 7 per cent to 7.5 per cent a year.
However, in the shorter term, the rental outlook is weaker than it has been for some time. This is particularly true in the retail and industrial sectors, although other parts of the market such as offices are contin- uing to see marginal rental growth.
Property rental incomes are usually protected by upward-only reviews and the level of rents being paid to fund managers is usually significantly above the level of market rent.
However, as the UK economy is now in a recession and with a number of casualties to date, this could lead to limited rental growth and falling income in the short term.
We prefer income-focused commercial property funds at this time and anticipate that any further reductions in valuations will have a lower impact on those income-focused funds which are less driven by capital appreciation.
I believe that even at current valuations, property investment is once again beginning to look an attractive asset class for pension fund investment. However, trustees need to ensure they are confident that the market has levelled out sufficiently before any investment should take place.
Pension schemes that are considering investment into property should do so after consulting with their principal employer and checking the rules of the scheme.
We would also advise that pension schemes ensure they have sufficient liquid funds to meet short-term cashflow to prevent the need to disinvest in the short to medium term.
The risk that commercial property capital values will depreciate further and the fact that round-trip costs of investing in property are in the order of 7 per cent (including stamp duty), means that any disinvestment in the short to medium term will hinder the overall performance of a pension scheme’s investment portfolio.
In order to ensure that pension schemes correctly utilise property as a means of diversifying the scheme’s assets but continue to manage investment risk, pension scheme trustees should establish maximum exposure levels to commercial property. This will vary from scheme to scheme but commercial property exposure would typically be restricted to around 10 per cent to 15 per cent of a pension scheme’s total valuation.
Pension schemes that are considering investing assets into commercial property should ask their investment consultant to review the fund managers in the market over the next few months.
This will mean that once markets have levelled out, pension schemes will be able to act promptly to pick up the subsequent potential upside that undoubtedly exists in the commercial property market following the recent sustained falls.
Commercial property remains an attractive asset class for pension scheme trustees due to its diversification potential and lack of direct correlation to both equity and bond markets.