As 2014 gets underway in earnest, the mood around commercial property has been increasingly positive. The IPD index showed that commercial property in the UK saw growth of 4.7 per cent over the final quarter of 2013, a very respectable 7.7 per cent over the last six months of that year, and 10.9 per cent over the past 12 months.
And looking forward at prospects in the commercial property arena for the coming year, the current sentiment appears to suggest that this positive upswing will continue. Ignis Asset Management, which runs one of the largest commercial property funds with £1.1 billion under management, has said that it predicts returns of 11.5 per cent in the coming year. In the Ignis UK property forecast for 2014, Ignis UK Property Funds manager George Shaw says: “The majority of capital growth is expected to be generated by yield compression. This in part reflects the intensive competition for the limited number of quality assets available, as an increasing number of investors seek exposure to the asset class.”
It’s a view that is shared by many in the City. Aon Hewitt senior consultant Richard Cooper says: “I think there are a few factors that have come together to suggest it’s going to be a good year for commercial property. Demand for prime property has been continuing since 2009, while secondary values have generally fallen. Sentiment has improved now and there is more interest in secondary assets with shorter leases and poorer quality tenants.”
Hermes Real Estate director of international investment Ben Sanderson also argues that positive performance in the UK commercial property sector is something of a continuing trend, rather than necessarily a recent development. “I would agree that the outlook is positive, but it has been positive for the past six months or so,” says Sanderson. “But what is interesting is that we are seeing some of the strong traditional income characteristics of real estate being complemented by some strong capital growth. This is mainly because of yields falling rather than rental growth, but investors are nonetheless buying in anticipation of rental growth.”
What’s more, Sanderson says this is a story that is expanding across the regions. “That dynamic, which has been very strong in London, is now starting to spread into the regions as well, and returns are getting stronger in the regions.”
And for Sanderson, these factors are increasing the appeal of property for pensions. “From a pension fund’s perspective, that, in a nutshell, is why a lot of asset allocators are looking to up [allocations to commercial property] today. It’s that classic combination of income and growth.”
A ‘traditional alternative’
Indeed, for pension schemes, commercial property has long had a natural appeal, as PiRho Investment Consultants director Phil Irvine explains: “Property has been the ‘traditional alternative’ to bonds and equities for decades. Whilst not a matching asset in the normal sense of the word – returns are not directly linked to the present day value of pension liabilities – it has historically given returns linked to inflation. So it fits within ‘growth or return seeking assets,’ with some matching characteristics.”
And of course, compared with some of the more complex instruments available to pension schemes today, commercial property is a refreshingly straightforward asset class. “It’s a readily understandable asset class,” says Cooper. “It’s also a tangible asset. You can actually go and see what you physically own. Although this can have its downsides; there can be illiquidity issues.”
Indeed, this is one of the snagging points for investors. With no central clearing house and no straightforward way to buy and sell commercial property, direct investment is usually reserved for the very biggest funds. “The act of buying and selling is quite complex,” says Sanderson. It involves numerous stages from examining title and lease structures through to covering costs such as stamp duty and other fees. There is also something of a myth surrounding the idea that assets will always increase in value. “Investors do need to understand about the idea of a depreciating asset,” says Sanderson. “In reality, assets do not always go up in value. You have got to put money into them to maintain value, you might need to move tenants around and work with short leases to maximise your income.”
There is also the matter of diversification. “Pension schemes that do invest in property typically diversify between the various property sectors – office, industrial and retail – as well as individual properties,” says Irvine. “Unlike individuals, pension schemes are able to access a far greater range of investments, so they don’t just have to stick with what’s familiar and immediately accessible.”
Certainly, pension schemes have been heading outside that traditional core of commercial property to invest in less habitual real estate. Take the example of the London Borough of Waltham Forest and Surrey County Council pension schemes, which have invested £20 million each into the Darwin Leisure Property Fund. The fund is the only one investing in the £36 billion holiday park industry.
Cooper acknowledges this trend, but remains cautious. “Our managers have the opportunity to invest in what we call alternative sectors,” he explains. “There are funds investing in doctors’ surgeries and marinas, and others with exposure to pubs and hotels. We wouldn’t put funds solely in that kind of asset, but they can be used to diversify risks. In all cases, the relevant underwriting and due diligence is necessary. But we support managers going off piste to find better value.”
But while diversification may be more freely available, for direct investors, it requires considerable scale. “Only the largest schemes have their own in-house managers and the smaller schemes tend to invest in pooled products,” says Sanderson. For schemes at the less huge end of the scale, pooled funds are the only realistic way in, and they offer a number of advantages. The technicalities of buying and selling property are dealt with much further up the scale; there is scope to sell units on the secondary market – and scope to buy there too. As Cooper explains: “If we are trying to get clients exposure to pooled funds, we usually attempt to do so on the secondary market, where prices are often slightly lower. If you subscribe directly into property funds, then you will find that the offer price includes a spread reflecting stamp duty and so on, which can potentially be saved by acquiring units on the secondary market.”
Indeed, specialist commercial property funds are not the only place where exposure to this asset class is available. “These days, accessing property returns is a feature of a number of ‘diversified growth funds’, which are a popular way for investors to access a broad range of asset class returns in a co-mingled fund,” explains Irvine.
Of course, investors understand the positives of property investment, and they also have a greater understanding of the risks that may be involved – namely that of the bursting of a property bubble. Shaw remains positive on this front. In the Ignis Property Forecast, he says: “Our analysis shows property yields can sustain a moderate re-rating over 2014, without moving into bubble territory. Since the market started to recover in 2009, a more appropriate allowance for price discrimination across markets has been applied.”
He goes on to explain: “Average property capital values remain about 30 per cent below the previous peak recorded in 2007. Those sectors that continue to face fundamental challenges remain significantly behind, while markets with clear growth prospects have recouped a much greater proportion of those capital declines. We are confident memories of 2007 are recent enough to prevent the industry going there again.”
Right now, though, investors are queuing round the block to secure a piece of the commercial property action. As Cooper says: “A number of fund managers have placed queues on subscriptions into their funds, so that investors are effectively on a waiting list. It just goes to show how hot the market is starting to get.”
Sandra Haurant is a freelance journalist