Time to cool off on UK commercial property?

The whole South East has seen a surge in prices for all types of property

Funds investing in UK commercial property have racked up annual returns of over 12% in the past five years, but managers are now trying to damp down investors' expectations.

time to cool off on uk commercial property

Time to cool off on UK commercial property?

Some high-profile sales of ‘trophy’ buildings, such as the City’s gherkin, on yields of only 4%, have highlighted the fact that UK offices are no longer cheap. You have to assume a lot of growth in future rents if you are going to buy an office for a return less than you can get by buying gilt-edged government bonds

Indeed, the whole South East has seen a surge in prices for all types of property (shops, offices and industrial) so that in future, increases in capital value will depend much more on getting tenants to pay higher rents. That’s fine when the economy is booming, but as we saw back in the early 1990s, a recession can mean rents are static for three or four years.

How our selected Property funds have performed

 Fund Six months  One year Three years Five years
 M&G; Property +5.0% +9.9%NA  NA
 New Star Property +4.9% +11.6% +46.7% +74.2%
 SLI Select Property +19.6% +27.2% NA NA
 Sector Average +8.5% +13.9% +65.9% +106.1%
 SWIP European +18.6% +26.7% NA NA

Data to 29/3/2007. Source: Trustnet

What is a property bargain in this market?
The fact that prices have surged and cut rental yields means managers of UK property funds are having to search further afield for bargains. But then the question arises of whether they really are bargains. Several managers have told me they think the gap in valuations between ‘prime’ and non-prime property has become too narrow.

By ‘prime’ they mean buildings in the very best locations, constructed to high standards and occupied by blue-chip tenants (the government or big companies). These should command a premium – but today that premium is lower than it has ever been.

There is also a big unknown on the horizon, and that is the new drive for energy efficiency and environmental friendliness. How long will it be before most UK companies have to follow the likes of Marks & Spencer and commit themselves to ambitious environmental goals? And what impact could that have on the property market? Will it force landlords to spend a lot of money on refurbishment? And will that benefit landlords (more rent) or harm them (same rent for a better building)? I’ve asked these questions, but at the moment all I get is shrugs and ‘don’t knows’.

There could be trouble ahead

One thing I have learned in 30 years of watching markets is that markets dislike uncertainty and mark down prices to compensate for it. And I wouldn’t be at all surprised to see this happen in the property sector as people begin to expect higher environmental standards to be either demanded by tenants or mandated by government. That emphasises the importance of owning ‘prime’ assets. That’s one of the reasons why I like the M&G; Property fund – manager John Cartwright is a cautious chap who likes top-quality assets.

So much for factors affecting the value of the bricks and mortar. On top of that we’ve seen the introduction to the UK of Real Estate Investment Trusts (REITs), which allow companies to own and manage properties in a more tax-efficient way.

All well and good, but the euphoria over REITs has seen the price of shares in property companies like British Land and Land Securities soar over the past few years, to the extent that their price is now equal to the value of their assets. Many property funds (like one of our selections, New Star Property) have owned shares in these companies and have benefited hugely from the rise, but can’t look forward to similar returns over the next few years.

Still expecting decent UK returns
So, while strong economic growth means rents will probably go on rising, and that means capital values will also rise, most managers are expecting annual returns from UK property to be around 7-8% over the next two years. That’s well below recent rates and may leave investors disappointed, though I’d say it’s a reasonable return from a relatively stable asset.

The arrival of REITs, and the prospect of lower returns in the UK, has encouraged managers to launch funds investing in worldwide property – Fidelity, Skandia, Franklin Templeton and JP Morgan among them. But there is a catch, in fact two big catches that I fear many buyers of these funds aren’t taking into account.

Review our Best Buy Property funds here

Two problems with REITs

Catch #1: REITs are not properties… they are companies that own property
Most of them borrow money to do so. 50% of the typical US REIT’s assets are financed not by shareholders but by borrowings. This makes investing in REITs inherently more risky than buying a traditional ‘bricks & mortar’ fund like M&G; Property.

It also means you need to get a higher return from REITs to compensate you for the risks created by that borrowing. In fact, if a fund has 50% borrowings, it should generate returns of 50% more than an ungeared fund like M&G; to deliver the same risk-adjusted return to investors.

Catch #2: REITs are not properties… they are shares.
Historical data shows they have tended to move more in line with property prices than share prices, but that their performance is converging towards that of the stock market rather than property. This is a logical consequence of more investors buying REITs on a global basis, and it means you get far less ‘diversification’ benefit from buying a fund investing in REITs than you do from one that buys physical property.

Take the two catches together and you can expect funds investing in REITs to be far more volatile than those that invest just in bricks and mortar. At the moment, they still look a good proposition, because in many areas property prices look low in historical terms and in relation to interest rates. But in any sharp stock market fall, the prices of these funds will fall too.

Smarter management needed to avoid problems
For this reason my international fund selection is Standard Life Investments Select Property fund. This does invest in REITS in many countries, but it also buys physical properties, which it can do because its parent Standard Life has teams of property experts on the ground in places like Japan (where it now has 18% of its money invested) and Australia. Manager Andrew Jackson and his team are an impressively knowledgeable bunch of people and have recently taken steps to protect investors from falling share prices by using derivatives.

One fund I have been keeping an eye on is SWIP European Property. This also invests in REITs, exclusively in Europe, and is I think a good short-term buy because, for various historical reasons, a lot of European property is underpriced, especially in the East European states that only joined the EU recently.

This fund may well turn in better numbers than most in the sector over the next 12-18 months, and if you are an active investor who is prepared for higher volatility, it’s worth a closer look.

Important risk warning – please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice

UK commercial property & Equity Release

What Is Equity Release?

Equity release is the use of financial arrangements that provide the owner of a house, or other property, with funds derived from the value of the property while enabling them to continue using it.

How Does Equity Release Work?

Equity release is aimed at homeowners aged 55 and over. It allows you to take some of the value of your home as cash.

Equity Release on Property Investments or Real Estate

In its simplest form, a real estate private equity fund is a partnership established to raise equity for ongoing real estate investment. A general partner (GP), henceforth referred to as the sponsor, creates the fund. The sponsor asks investors, known as limited partners (LPs) to invest equity in the partnership. Those funds, along with money borrowed from banks and other lenders, will be invested in real estate development or acquisition opportunities.

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