Two years or so after the start of the financial crisis, it is timely to reassess the rationale for holding commercial property as part of a balanced portfolio and review how private investors can access the market. It is also worth considering, in light of the turbulent experience of recent years, how investors’ property portfolios might be structured in future.
Commercial property markets typically comprise retail (such as shopping centres, retail warehouse parks or shop units), offices or industrial premises.
Property markets are characterised by large, ‘lumpy’ assets. The average building size in the UK, across all sectors, is over £10m. Certain property types, such as shopping centres or central London offices, could trade for several hundred million pounds each. It is impossible, therefore, for all but the largest investors to assemble a credible direct portfolio with sufficient critical mass and diversification.
For retail and small/medium institutional investors, accessing the market indirectly, via pooled funds, represents the only realistic way of gaining exposure to the sector.
Property funds tend to invest either in direct property or in listed property equities (such as Real Estate Investment Trusts). Direct property funds hold physical buildings and often cash or listed property equities to provide liquidity. Listed property securities funds hold property equities, which form part of the wider equity market.
The two main reasons for holding property as part of a balanced portfolio are to deliver acceptable returns and to assist the diversification of risk.
Direct property returns are delivered in two ways. First, investors receive income through the rental payments contracted by businesses under leases. Second, performance can be delivered through changes in capital values, which are either due to changes in rental values (reflecting demand/supply conditions in occupational markets) or because of fluctuations in market yields (reflecting shifts in investor sentiment).
The balance between income and capital returns varies over time. Rental values are positively correlated with economic growth due to the associated increase in demand for space by businesses. This relationship is usually lagged because of the delayed impact of increased activity on occupational decisions. It is also complicated by the impact of construction, since the oversupply of new space can lead to falls in rental values, particularly when then accompanied by falling GDP, as evidenced by the City of London office cycle in the late 1980s and early 1990s and Dublin today.
The income component of performance tends to be more stable. Prevailing lease contracts and rent reviews, which in the UK are typically every five years, mean that increases in rental values do not immediately feed through to income. At the same time, investors’ income is partly protected from falling rental values because of irregular rent reviews which, in the UK, are usually on an ‘upward only’ basis.
At around 480 basis points, the current gap between property initial yields (rental income as a proportion of capital value) and five-year gilt yields is close to the highest margin on record, in marked contrast to the late 1980s/early 1990s, when property yields were consistently below gilt yields. As chart 1 below also shows, property yields usually stand at a premium to equity dividend yields. As a result, property often plays a useful role in generating income to mixed assets portfolios.
The second reason for holding property as part of a balanced portfolio is to assist risk diversification. Direct property tends to be weakly correlated with both equities and fixed income markets. This is helpful in reducing the overall volatility of returns.
Correlations tend not to be stable and it is therefore helpful to look at trends over time. Chart 2 shows UK direct property’s correlation with UK equities and gilts over rolling 36-month periods. Property’s correlation with equities averages around +0.1, which is not significantly different from zero, and generally falls within the range of – 0.2 to +0.4. There was no significant hike during the financial crisis.
Property’s correlation with gilts has averaged – 0.2, and has fallen since the start of the financial crisis. In short, property’s diversification qualities remain strong.
Traditionally, any exposure UK investors have had to commercial property has tended to be UK-focused. What can be learnt from the financial crisis and how might this change the traditional approach to holding property?
a) Global, not local
There is a strategic case for considering property on a global, rather than purely domestic basis. Property markets tend to be local markets. Rental levels are driven by local demand and supply factors. Relative to listed equity and bond markets, which are highly integrated and strongly correlated with each other, direct property markets tend to be segmented and weakly correlated. This is good for diversification.
There can also be tactical benefits from taking a global perspective. UK commercial property capital values fell by over 44% between June 2007 and July 2009 according to the IPD UK Monthly Index, representing the sharpest decline in the 23 history of that Index. By taking a global, rather than local perspective, it is possible to avoid such downturns and take advantage of higher prospective returns outside the UK.
b) Maintaining liquidity
While some direct property funds – notably the Authorised Unit Property Trusts – remained open and their managers should be credited for maintaining liquidity in difficult circumstances, many direct property funds, particularly those designed for institutional investors, suspended redemptions requests during the downturn. Ensuring an appropriate level of liquidity, either through cash holdings or listed property securities, can help prevent redemption problems in extreme market conditions.
c) Fund of funds
It is extremely difficult, if not impossible, for any single organisation to have the specialist property investment skills and presence in the key centres of the world. A ‘fund of funds’ approach enables a manager to select specialists. It also means that the exposure to property is not unduly weighted to any single manager, and the financial crisis emphasised the benefits of manager diversification.
In summary, property has the ability to generate attractive returns and provides strong diversification qualities as part of a broader investment portfolio. Considering a global perspective, possibly through a fund of funds route, offers the potential to secure higher returns over the medium-term, and further reduce overall volatility.
Categories: Property Investment