UK commercial property’s attractive yields offer opportunities for the long-term investor

By Bridging Loan Directory -

 

Willem Sels, UK Head of Investment Strategy at HSBC Private Bank says commercial property is one of the key asset classes that we believe can add value in a prudent investor’s diversified portfolio according to Property Funds World.

The illiquid nature of direct commercial property investments and the heterogeneous characteristics of the underlying assets make investing in the asset class more challenging than for traditional securities.

Furthermore, the potential returns that are offered by the sector are typically only realised over long holding periods. Nonetheless, for investors who have the composure to hold investments over the medium to long-term, the potential returns and risk reduction benefits from holding direct commercial property can be significant.

2011 proved to be a decent year for investors in direct commercial property. Relative to other major risk assets, the total return index on the IPD UK All property index was the only one to register a positive return in 2011. In our view, the returns an investor could potentially earn from commercial property investments over the next few years are likely to be driven by two key factors, economic growth and its impact on inflation, and the price paid for those assets.

In simple terms, the return an investor can earn from investing in property can be broken down into two components, i) the capital gain, and ii) the income generated from the property after all expenses have been met. The level of economic activity will impact both of these elements. Commercial property in the right location is a relatively scarce commodity, thus in periods when demand is strong, say, when consumer spending is growing demand for retail properties will be strong. Likewise, when export markets and business investment are healthy, industrial and office space is more likely to be more sought after which, ceteris paribus, can lead to prices rising.

Furthermore, the economic climate will also be a key factor in determining the rents paid to the owners of commercial property, and this will determine the final income yield that an investor receives. Clearly when economic activity is robust, higher demand can put upward pressure on rents, which should buttress returns.

Sels believes that the outlook for the global economy – and within that the UK – is likely to be a challenging one. However, over the medium to longer term he believes that developed market economies can overcome the shorter term challenges and return to levels of economic growth that are close to those they enjoyed prior to the financial crisis. Although the Western world is likely to continue on its path of deleveraging (by both consumers and governments) for many years to come, this doesn’t mean that a protracted period of negative growth is likely, in our view. One of the key reasons for this is that the monetary authorities, especially in the UK and the US, are intent of following policies that support growth and, perhaps more importantly, prevent price deflation. This last point is especially relevant to “nominal assets” such as commercial property.

This last point probably deserves some clarification – real estate is often described as a nominal asset because the purchase price, as well as rental income, is received in nominal terms. Thus, as the general level of prices rise in the economy, rental income and capital values also usually increase. As can be seen in figure 3 below, the rate of price changes in the economy can be one of the factors that affect the returns earned from the commercial property sector.

Thus, when inflation is positive this tends to be good for commercial property returns. In our view, it would be stretching the argument too far if we stated that commercial property can act as a perfect inflation hedge, because history tells us that when prices rise too high, too fast, virtually all assets suffer. Nonetheless, as part of a diversified portfolio, we believe that commercial property can help shield investors from the negative effects of inflation.

The other key factor that determines returns is the price paid. Following the maxim that one would prefer to “buy low, sell high” is only part of the story though, as a significant proportion of the returns and investor earns comes from the income earned. Thus, says Sels, it is paramount to consider the yield available on commercial property.

Initial yields (income/price) for the broad market currently are marginally below long-term averages. On its own, this may imply that the future returns available are likely to be less attractive than in the recent past. However, this indicator may be too simplistic in our view, as we believe it is important to look at commercial property yields relative to other income generating assets, in particular government bonds.

In comparing the yields spread of the broad commercial property indices relative to government bonds they are close to recent highs. This probably bodes well for future returns as the low yields available on cash and bonds could lead investors towards commercial property. Thus although the sector performed well last year, the significant outperformance of government bonds leaves commercial property looking relatively attractive.

Commercial property in the UK proved to be one of the better performing asset classes last year, nonetheless, current valuations suggest that increasing exposure during in the present markets may be rewarding for investors over the long-term.

Commercial property is an illiquid and heterogeneous asset class which means that selecting exposure to the best properties in the most desirable locations is key to ensuring the maximum possible returns and reducing volatility. Although the near-term outlook for the UK economy is challenging, Sels believes the longer-term outlook is more favourable and over this time horizon we believe that commercial property investments will deliver decent returns.