“A key measure of value is the initial yield on the IPD Index, which got as low as 4.6% at the peak of the bull market before rising to 8% in mid-2009. Following the rally of the past six months the yield has now moved back down to 6.8%, which indicates reasonable absolute value. In relative terms, it is normal for property to offer an excess yield over gilts to account for the illiquid nature of the asset class. At the peak of the market property briefly yielded less than gilts, which was clearly unsustainable. In the depth of the crisis the excess yield reached almost 4%, which we viewed as a very clear buy signal. It is now down to around 2.7%. Compared with a 10-year average level of 1.7%, we believe that this still represents good relative value.
“Despite this evident value, investors should be aware that risks remain. Although an economic recovery is now underway, the level of growth is likely to be constrained for several years by deleveraging and government austerity measures. As the government seeks to address its debt position, cost cutting measures are likely to impact the amount of space occupied by a number of agencies and departments. Meanwhile, banks are still facing high levels of impaired property-related debt. As pricing recovers, some of this property is likely to find its way onto the market and much of it is likely to be of questionable quality. Finally, the flood of liquidity caused by quantitative easing is now waning as the authorities scale back emergency support to the financial market. How this withdrawal of liquidity affects markets - equity and bond markets as well as property - is still unclear.
“The economy-related risks and liquidity injections highlighted above have led to an unusual dynamic between prices and rents. Normally, prices only rise when rents are growing, but currently the backdrop of sluggish economic growth and cost reduction at the corporate and government level are muddying the rental picture, while liquidity and asset allocation flows are driving up prices. There have been signs of rehiring in pockets of the economy, but rents in many areas may remain under pressure for some time. It is important to note, though, that the rents received by our funds are partially insulated by the long lease structure that characterises the UK commercial property market. When a tenant signs a lease agreement, they pay the initial rent for the term of the lease, irrespective of changes in the market level of rents. This visibility of income is part of the appeal of UK commercial property.
“Indeed, following the violent swings in pricing driven by liquidity flows out of and then back into property over the past three years, we expect income to resume its normal role as the principal component of total returns over the coming years. This view is borne out by property derivative pricing, which implies high single-digit per annum returns from the market over the next seven years. This is the type of return profile that investors can reasonably expect from property over the long term. The caveat, therefore, is that if we see further significant capital returns in the short term, these may be effectively borrowing performance from future periods.
“The supply picture is much healthier today than it was in the last property downturn. In the early 1990s, high rents drove a development boom that subsequently created a glut of empty space as the recession hit. This time, development activity has been much more muted. Even in the City of London, which is most prone to over-development due to its easier planning regime, the volume of new development underway today is only around a third of what it was in the early 1990s. This suggests that rents will remain under pressure for a shorter period than they did in the 1990s.”
