Despite institutions being able to invest in both residential and commercial property, neither is a particularly large part of institutional portfolios and many have no exposure whatsoever to either market.
Those funds that do have exposure, however, will have benefited quite considerably from that allocation decision in recent years, with the performance of property significantly outpacing that of equities and bonds.
Asset allocators tend to regard both types of property separately, but for how long should commercial and residential property remain two distinct areas of investment?
Investors have historically bought into these markets for different reasons:
Institutions have invested in commercial property as they are seeking a total return for clients, both income and a capital gain. They are also able to add value to the properties they hold through a number of methods.
Homeowners primarily want simply to own a suitable house at an affordable price. While the concept of investment returns is important, it is not the main consideration. The buy-to-let market has so far mainly been the domain of small investors, who are generally looking for capital growth, as rental income is usually reduced by relatively high costs of management.
Another crucial difference is the level of risk assumed by the investor. Institutions traditionally have been risk averse when it comes to investing in commercial property and tend to prefer little or no gearing. This contrasts with the residential market, where investors, especially first time buyers, have had to gear up to the hilt out of necessity.
Institutions have also generally shied clear of the residential market because of the heavier regulation attached to this market, the relatively small lot sizes, and consequential higher management input relative to commercial property.
But for all their differences, there are clear similarities between the two areas of property investment. Generally, when the economy is doing well, there is a feel good factor, which is positive for both the residential and commercial markets. Conversely, if the economy is performing poorly, then both classes of property are less likely to do well.
These economic factors have also meant that, over the last thirty years or so, the correlation between capital growth in commercial property and owner occupied residential property has been high.
Looking at residential property, there are an increasing number of people who cannot afford to buy a house and so must rent. But interest rates are rising, making the cost of borrowing more expensive and putting pressure on buy-to-let investors. So now these investors face the dilemma of whether to stay in the market, leave the asset class altogether or turn their attention elsewhere, including commercial property.
With most of us owning our own houses and indirectly investing in commercial property through insurance and pension contracts as well as saving plans, around half of UK individuals’ net wealth is tied up in property. Institutional portfolios have also increased their holding in commercial property in recent years, as equities have languished and bonds become increasingly expensive. Property, therefore, is likely to remain an important part of UK investment for years to come, even without any significant switch into residential.
The prospect of the two areas of property investment merging in the future is far less likely. While there are similarities and some crossover currently exists, there are still some significant barriers. Therefore, our fund managers do not expect a marriage of the two asset classes in the near future.
This article is an edited version of a longer article that appeared in the August 2005 edition of the Scottish Widows “TechTalk” magazine.
