The UK commercial property market will begin to recover later this year and selective entry into this market could provide excellent risk-adjusted returns, according to a new report by Cordea Savills, the international property fund manager.
The report predicts that by the end of 2009 UK capital values will have fallen around 50% from their 2007 peak, yet argues that this short term distress is creating a 'window of opportunity' for investors to purchase high-quality commercial property, with secure income, at attractive prices. For investors with Euros or US dollars, entering the market during this decline could offer even greater opportunities with a 20% retreat for Sterling giving a 70% peak to trough fall in capital values according to market indices.
However, indices only reflect part of the story. In reality, a two-tier market for commercial property is emerging in the UK. This is reflected by an increasing demand for prime property and continued malaise in the secondary market. Prime assets with very long dated income (i.e. leased to tenants for over 10 years until first break) that are let to high quality covenants (for example UK Government or the UK's leading supermarket) have been recognised for their exceptionally well priced, low risk income (circa 7.5% per annum). Investors have started once again to refer to the "bond-like characteristics" of such property investments. This contrasts starkly with properties let on shorter leases (i.e. those which may have to be re-let in a very weak tenant market over the next 2-3 years), with weaker covenants or development opportunities, which have yet to really see any purchaser-led demand return.
Property is ultimately a cyclical play; investors entering the market to secure income can also expect to benefit from improving capital values as the recovery commences.
The report also states that the risk premium between property and other asset classes is now so wide that there will be an inevitable movement of investor money from bond assets to their property equivalent. Against other asset classes the Net Initial Yield from UK property at 7.66 per cent (March 2009) is notably high; the dividend yield from the FTSE All Share Index was 5.12 per cent in March 2009 and gross redemption yields on 5 15 year gilts was 3.73 per cent in the same month. Furthermore, Cordea Savills predicts that the yield for IPD All Property will reach 9% by the end of the year.
If property is considered as a fixed income asset, then it also provides three potential further advantages over fixed income bonds:
- Property rents are typically paid in priority to corporate bond payments (excluding secured debt), thus in financial default a rent is paid in advance of the coupon on the bond
Furthermore, in financial default a corporate bond does not leave the investor holding a tangible asset, contrasting with tenant default in property where the investor is left with the land and buildings upon it
- Property provides what is referred to as an 'equity warrant' the nature of the UK lease structure provides a potential free-ride on any future market rental uplift; no such mechanisms exist on standard bonds. Such a characteristic is uniquely strong in the UK compared with the rest of Europe
- Property also provides opportunities at the termination of the lease, the asset providing both a residual value and of course the potential advantages of alternative tenants and building uses
The report rejects the argument that the UK economy is set to experience a protracted period of turmoil, akin to Japan's 'lost decade' and suggests that the timely introduction of substantial fiscal stimulus packages early in the crisis will be reflected in a swifter economic recovery than other European markets, which have been slower and less decisive in their response.
George Tindley, Director of Investment at Cordea Savills, commented, "The UK is one of Europe's core property markets, accounting for 29% of its investible market size. As well as its scale, it is highly transpar