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Prime prospect

Cherry Reynard assesses the return of value to the commercial property sector

Property has been the quietest part of the scramble for yield with many retail investors still bruised from their experiences during the credit crisis. Yet the IPD index shows that property now has an overall yield exceeding that of the higher-quality end of the corporate and government bond markets, and the yield on the FTSE All Share.

The questions for investors are whether, in the face of weakening economic growth, the yield is sustainable and whether it may come at the expense of capital growth.

According IPD figures, property currently has a yield of over 6 per cent. At the top of the market – June 2007 – the average yield was around 4.5 per cent. In the intervening period, it has gone as high as 7 per cent. The average yield on property funds is lower but this includes global property funds with little or no yield.
In contrast, the yield on the All Share is currently 3.62 per cent and that of the 10-year government bond 2.3 per cent.

In theory, this looks attractive but parts of the commercial property market look increasingly weak and there are questions over whether yields are sustainable.

The high street, for example, is struggling as consumers find their spending power hit by the Government’s austerity measures, job insecurity and a weakening economic climate. Vacancy rates on the high street in some parts of the country are estimated to be as high as 30 per cent. In this climate, there are questions over whether landlords can retain pricing power, which is putting downward pressure on rents.

Premier pan-European property fund manager Alex Ross says: “Income on different types of property is very different. Now there is slow economic growth, investors need to be very diligent in selecting real estate.”

Royal London Asset Management property manager Stephen Elliot agrees that property managers have to be extremely discriminating to avoid erosion in yield and says: “There are risks surrounding tenants generally. The ones that are high profile tend to make headlines but there have been office and industrial occupiers also struggling. There are also huge regional gaps between how high streets perform. We are very careful about the towns and cities in which we invest.”

He remains bearish on a significant chunk of the UK property market, saying t there is almost no market for secondary property in poor locations. Both managers are instead focused on the prime end of the market, which means the “best quality, the best located and the best let real estate here and on the continent, according to Ross. Elliot says: “There are pockets in more affluent areas that are doing very well. We are going back to basics and location is vital.”

Ross says some sacrifice in yield is needed for prime property but it is still yielding around 5.75 per cent, significantly ahead of the 10year gilt, and wider than it has traded historically. The income has also proved stable in the past.

Over the period 2007-09, Ross points out, the income for British Land fell by just 1 per cent.

An erosion in capital values caused the net asset value to bounce around but the income was largely unchanged.

In retail property investment “prime” means the major Reits that are entirely in prime destinations, with long leases (10 years or more) and let to the stronger retailers.

Ross believes that this type of property is exposed to a structural growth trend that sees the major retailers – Apple, Primark, Forever 21 – wanting to consolidate into big stores in big shopping centres. This means centres such as Westfield in West London that have significant footfall and high visibility. Retailers build flagship stores and use them in conjunction with their internet offering.

Ross adds: “Pricing is pretty stable for this kind of property and tenants have not got huge pricing power. There is some structural demand.”

A key advantage of commercial property over other sources of income has traditionally been that it is a good long-term inflation hedge but this is dependent on being able to push through rental increases.

Elliot points out that if landlords do not have pricing power, they do not have an inflation hedge. He suggests that the ideal situation is places such as the West End in London, where supply is limited.

Ross believes that looking abroad can provide a strong hedge against inflation. He points out that rental yields in some parts of continental Europe are tied to CPI/RPI each year. In the UK, rents usually only adjust every five years or so. Managers such as Jim Rehlaender at Schroders have gone further afield, investing in emerging market property.

Multi-managers have tended to look further afield when selecting the property part of an income portfolio.

For example, Architas chief investment officer Caspar Rock holds little in conventional property assets, instead preferring infrastructure assets and also unconventional holdings such as the doctors’ surgeries investment trust Medicx. The latter has 30-year upward-only rent reviews, supported by primary care trusts.

Thames River Capital joint head of multi-manager Rob Burdett, holds a caravan park investment trust, which has been a beneficiary of the recession and provides a yield in excess of the wider yield on property.

Elliot concludes: “Property has always been an income play. People lost sight of that as the increase in capital values was so large. Now we are in an environment where capital growth is likely to be broadly flat, so income is once again why people are investing in property.

“Is the yield sustainable? It does not look highly valued compared with June 2007 but there again, we are in a fundamentally different world. I certainly do not think it is overvalued. It is perhaps fairly valued at these levels.”

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