No way, says James Ferguson – it’s heading for a fall
Commercial property had a storming 2004: the sector rose more than 18%, and many investors made a great deal of money. Will they do so again this year? Paul Herrington, managing director of F&C’s property division, thinks so. While he admits that 2004 was so good as to be an “aberration”, he still forecasts a further 10% return in 2005, a rate of growth that he says is “sustainable”. And that, he says, is why F&C has taken the opportunity this month to launch “the largest listed property trust to date in the UK”.
Don’t believe the hype. We are told that the average long-term real total return from commercial property is 6%, but if you look at the small print, you will see that the anticipated nominal yield from this fund is 6%, which doesn’t sound too good to me, given that you can get 4.8% from a ten-year gilt at the moment. If you account for inflation (using a retail price index at around 4%), the 6% nominal yield implies an income of just over 2% in real terms, only a third of the 24-year average. This suggests F&C is expecting capital growth of at least 4% this year in real terms from the property they’re putting into the fund.
I can’t see that happening. The important thing in F&C’s eyes seems to be that commercial property is on a roll. Herrington claims investors have already “piled” into property and “invested a record £48bn in 2004”. This is an increase of more than 70% over 2003. That probably isn’t sustainable, and what’s more, you have to wonder whether using recent above-trend growth to justify a big fund launch is really the best way to do it. After all, don’t we all rather regret those technology funds launched in 2000 because of the great returns from the dotcom surge in 1999?
Indeed, to my mind, the fact that the market has enjoyed such a strong year is a reason to avoid it. All markets have the tendency to cap a strong run with a final, even faster, surge. This is what technical analysts call ‘acceleration’ and it is seen towards the end of fairly long trends – think of the last stages of the dotcom bubble, or the recent 25% year-on-year gains being seen in house prices. The next move is usually down. Another reason to be cautious is the mathematical tendency for statistical distributions to revert to the mean. After a storm, there’s calm weather. After a bubble, there’s a crash. Anything that ranges around an average will, over time, return to that average: to return to the long-run average, periods of excess return are likely to be followed by bad periods, and the whole lot averages out. So, mathematically, what we’d need to see to time our entry into commercial property well would be a recent poor run, preferably with a sharp sell-off (acceleration) in the most recent period. What we’ve witnessed is the opposite. That should be ringing alarm bells.
Still, the technical side of the equation could be over-ruled in the near term if the fundamentals are good enough. Here, F&C’s argument is that “commercial property investment is all about buying an income stream and the extent to which it is secure”. This is disingenuous in the extreme. It’s like saying bond investing is about the level of the coupon paid and the extent to which that’s secure, rather than about the fact that capital values can fluctuate and that the capital values of all income streams are primarily determined by the appropriate discount rate. As interest rates fall, the capital value of any income stream rises, and vice versa. The trouble here is that real long-term rates aren’t falling. They’re at a 300-year low, according to David Miles, chief economist at Morgan Stanley. “One thing which is clear,” warns Miles, “is that interest rates tend to revert towards the mean over time. So I am afraid that means interest rates are likely to rise from here.” And that must signal falling commercial property values.
To me, this is a classic case of the industry launching funds when they can, rather than when it might better suit investors. Long-term (24-year) real returns have averaged 6% compared to the 2000-2003 average of 6.75%, and last year accelerated to 14% (in real terms). This implies that, after a period of outperformance, 2004’s return was a good two or more standard deviations above the mean. Recent acceleration, the tendency for mean reversion, and the interest environment – all this implies that a period of below average (less than 6%) real returns is overdue. So why buy this kind of fund? I wouldn’t bother.
Yes, says Christopher Claxton – it offers among the best, and safest, returns in the market
While the experts are debating furiously the outlook for equities, gilts and residential property, not enough of us are paying attention to the UK’s undiscovered goldmine – commercial property. Had you invested in a commercial property fund in 2000, you would have enjoyed an average annual 9% compound growth rate up to March 2003, even as the FTSE All Share index dropped by almost exactly 50%. And over the whole of 2004, commercial property turned in a healthy 18% growth. Furthermore, if you look to the IPD website at www.ipdglobal.com, you will see that, during the 33 years since 1971, commercial property has shown healthy growth in every single year except four. And even during those four years, commercial property has been a safer investment than the alternatives.
For example, when in 1973-1974 Britain suffered its greatest stockmarket crash ever and the FTSE All Share index nosedived a colossal 71%, commercial property declined by only 15.9%. In 1987, when the All Share index dropped an alarming 37%, the value of commercial property actually increased. It only started to decline slowly into the low single-digits during the years 1990-1994, when demand was weak and, due to a rush of previous building, there was a severe oversupply. Since 2000, even as the equity market has fluctuated wildly and the capital growth of gilts has been modest, commercial property has grown in value in a steady straight line. In all, over the last 23 years, the sector has seen an annualised (nominal) rate of return of 10.3%. Crucially, between 6%-8% of that was made up of yield.
When commercial property prices decline, they do so gently and at a different time in the cycle to equities. Equities go up much more slowly than they drop: when they fall, they really crash. Generally, residential property starts to fall not long after an equity crash, but commercial property doesn’t decline until later. Usually, by the time commercial property is falling, equities are recovering. Better still, there are no crashes in commercial property: month-by-month rates of decline tend to be quite comfortable, levelling off from positive growth to gentle decline by a per cent or two every month for two or three years before recovering. That means there is plenty of time to anticipate the coming drop and to switch into equities, which most likely will, by then, be going up. That, at any rate, is what the historical data say.
The factor that gives commercial property this magic edge, and which makes it quite different from equities, is the long-term role of rental income upon which capital values are based. The value of the buildings is important, but a substantial part of the price of a commercial property fund comes from the present value of future long-term rental income, supported by long-term leases of between ten and 20 years, which contain provision for rent reviews (and then only upwards) every five years. That gives commercial property remarkable consistency as an investment.Right now, yields are being pushed down slightly, but that is due to the huge demand for commercial property pushing up capital values. Commercial property sales hit a record £42bn last year, according to agents Lambert Smith Hampton, and demand for commercial property is high among institutional investors, property companies and wealthy investors from overseas, as well as from pension and life funds. A “wall of money” is coming into the sector, as one fund manager puts it. The rising capital values this has led to has more than compensated for any fall off in yield: based on February’s numbers, the sector is currently returning around 12% This looks like a reasonably sustainable rate of increase. The excess of demand for property over supply is likely to continue, thanks to Britain’s restrictive planning regulations and the shortage of land. Those who invest in well-situated and well-managed modern buildings in the southeast are unlikely to go wrong. Note too that there are fewer developers than there have been in past booms. And to avoid the kind of oversupply that occurred between 1990 and 1994, these usually prefer to build new offices only when they have a tenant signed up. In addition, there are none of the signs of overheating in the commercial property market that we see in the residential property market – commercial property values are well below their 1999 peak, so there is no bubble to burst. I think that if we add up the benefits – capital growth, long-term rental returns and the fact that commercial property is not a volatile investment – it still seems to be an excellent area to invest in. If the economy keeps running at 3% and employment stays high, that will continue. And if it doesn’t, there will at least be ample time to get out in the early part of any decline.
So how can retail investors get into the sector? One way is via the the New Star Property Fund, which boasts a growth rate of 17% over the last 12 months. Alternatively, consider the new F&C commercial property trust.