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Windows of opportunity

James Smith reports that after a stark fall in the commercial property sector which shook investors, some commentators believe the market may now finally be bottoming out and starting to offer value

Commercial property as an investment class is suffering from a severely tarnished reputation, displaying all the worst aspects of an asset class bubble in recent years.

Once considered a genuine safe haven asset, it is difficult to see property regaining this status in the fore- seeable future.

As with other markets, property has suffered the effects of the credit crunch, with inflated asset values drastically marked down amid worsening conditions.

But on the fund side, an additional issue came from the basic lack of liquidity when many of the investors that had piled into investment vehicles over previous years suddenly wanted out.

Several groups aggress-ively marketed commercial property three or four years ago and these funds quickly came to dominate inflows.

Aviva’s property trust, for example, was taking as much as £100m a week at certain points during 2006 but then saw assets tumble by £800m in two months as sentiment turned.

By its very nature, property is not a liquid asset and, unlike equities, cannot be sold immediately in order to return money to investors. This led to several groups having to limit redemptions on these funds – although this was primarily on the institutional side – and most had to value assets more frequently to reflect volatility.

Several commentators have cited all these factors as reasons why the closed-ended structure may be more suitable for direct property investment in future.

Many of the trusts out there have also struggled in performance terms but at least they have control of their flows and can manage them accordingly.

On the open-ended side, the Investment Management Association’s property sector – which mixes direct and real estate equity funds – reports an average 38 per cent decline over one year to March 2, which is hardly the textbook definition of safe haven.

But looking to the future, commercial property retains its diversification benefits as part of an overall portfolio and will still offer decent income via rental yields.

Most of the managers in the sector believe we are now close to a bottom in this market and are cautiously optimistic, particularly as valuations have been forced down so low.

M&G property manager Fiona Rowley says the UK commercial market is in the midst of a double-dip, as valuations move from a period of correction to one of adjustment to a cyclical downturn.

She adds that signs have been more encouraging at the start of 2009 following three successive record monthly falls in capital values.

The IPD All-Property monthly index saw a single-month fall of 2.4 per cent during January compared with drops of 5.3 per cent in December and 5.1 per cent in November.

Rowley says: “We expect the rate of decline to continue slowing over the next few months, although the very near term will undoubtedly remain challenging.”

Overall, she believes falling capital values are a result of weakening rental prospects due to lower tenant demand rather than shifts in yield expectations.

Rowley also points to early signs of stabilisation in prime yields, especially on smaller-lot sizes.

“We believe yields will peak later this year,” she adds. “Many properties are now attractively priced and the market as a whole is below what we would consider fair value. On that basis, the UK appears to be the best value core commercial property market in the world and its appeal to international investors should be further enhanced by the weakness of sterling.”

Rowley also highlights hat previous drops of this magnitude in UK property (in the mid 1970s and early 1990s) were followed by strong and swift recoveries in returns.

Elsewhere, Aviva’s real estate research director David Skinner expects significant further value declines this year but believes investors waiting for a market bottom could miss out on major opportunities.

Overall, he says macro factors continue to limit the number of able and willing buyers for real estate assets and transaction levels remain very low.

For this picture to improve, Skinner feels various shifts are needed, including greater visibility on economic outlook, improving credit conditions and real estate valuations looking fundamentally cheap.

He says: “In some of the markets where the correction has been fastest and most marked, valuations already look to have overshot fair value and opportunities have begun to emerge.

“The most prominent example of this is the UK where capital values had fallen by an average of 35 per cent by the end of last year from the June 2007 peak and initial yields had risen to over 7 per cent. Buying UK real estate off these numbers is certainly attractive by historical standards and relative to its conventional comparators.”

New Star’s UK property director Marcus Langlands Pearse also notes various encouraging signs for the sector, with lower interest rates, the falling pound and falling prices luring investors back.

But although yields stabilised across all sectors in January, he feels it may still be too early to call the bottom of the market.

He says: “The final quarter of 2008 was the worst on record, with UK commercial property values falling by 14.4 per cent, according to the International Property Databank. Property values responded to reduced liquidity, forced selling and a dearth of purchasers. The result was that yields relative to the risk-free returns from gilts rose to levels comparable with previous bottoms in the market. This suggests the potential long-term gains from buying property over the coming months appear greater than the potential for further losses.”

Langlands Pearse tempers this optimism slightly however, stressing that gloom is likely to persist for some time.

Rents are likely to fall and tenant defaults will rise as the recession develops, potentially causing further price declines.

In the longer term, however, he believes falling interest rates and the high yields available on property relative to bonds and equities offer attractive opportunities.

“The traditional benefits of owning commercial property are reasserting themselves as investors are attracted once again to an asset class that can offer compelling valuations, tangi- bility in a world of uncertainty and a strong and relatively secure income,” he adds.

Among advisers, many remain unconvinced in the short term, although they recognise commercial property’s long-term advantages.

Chelsea Financial Services managing director Darius McDermott says the asset class should be part of most portfolios as a long-term asset allocation.

That said, he is not a fan of buying in at the moment and would rather wait and see the commercial property market stabilise first.

He says: “Those who already hold it have seen values come down massively since the peak and are probably best holding on now. Commercial property has historically been linked to economic activity and that is clearly in decline at the moment.”


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