With equity markets reaching five-year lows and demographic changes likely to lead to an increasing demand for income, the property market looks set to benefit as investors look for greater security and higher yields
Over the past 28 years, the income from gilts and equities has approximately halved, while property yields have remained constant. As a result, property has emerged as the highest-yielding asset class, with a yield gap of over 2% above gilts.
Graph one includes the 1970's oil crisis, when both equity and property values crashed, and the subsequent high inflationary period, illustrated by the level of yields on gilts.
It also shows how the property recession of the early 1990s lagged the 1993 equity recovery and decline in interest rates. Without this delay, it is unlikely such a differential yield between property and gilts would exist today.
In other words, the pain endured by the property sector in the early 1990s may have resulted in an unsustainably high premium in property yields. We believe we will see an upward correction in property values in due course.
High property yields are in contrast to the recent trend in interest rates. Graph two contrasts a typical variable borrowing cost, assuming a rate 2% above base rates, with the Investment Property Databank average income return. This shows there is currently the extraordinary ability to fix the borrowing cost at a lower level than the initial yield, the rental income at the time of acquisition ignoring the potential to increase this at subsequent rent reviews.
The effect of utilising a bank's cash to supplement your own is shown in the table below, where we contrast the return from an ungeared office investment with one that borrows 60% at a fixed rate of 6% per year. The return on the geared investment rises from 12.7% to 16.7%.
The combination of an exceptionally high yield in conjunction with historically low interest rates means only marginal growth is required to deliver double-digit investment returns.
However, this demands that the property market does not go into the kind of slump that developed following the oil crisis of 1973-74 or the property recession of 1990-93. In this respect, we are fortunately not experiencing the kind of inflation or interest rates that caused the economy to contract spectacularly. More than anything else, high levels of interest rates unhinge the property market because debt forms such a critical part of its financial structure.
Even more important is that the property market is a great deal more secure than in the earlier recessions. The overheated property sector of 1973-74 and 1990-93 was fuelled by bank lending on speculative developments under which a developer borrows, develops and then seeks a tenant upon completion. The collapse of rental demand in conjunction with soaring interest rates wrought havoc in the sector as more and more developments continued to complete, adding to a mountain of unoccupied space. It is hardly surprising banks and developers have done their utmost to avoid a repetition of this.
Banks now require a tenant to be contractually committed before advancing their funding on a development, thus ensuring an income flow from the date of completion. Developers have had to surrender any rental growth during the construction period in exchange for the certainty of a let. The reduced level of property development is illustrated in graph three.
It is reasonable to conclude that property may achieve a return of close to 10% per year in a sluggish economy with modest rental growth.
Prospects may be even better when the economy reverts to its longer-term trend of economic growth.
One factor in particular could be dominant. The average property content of a pension fund portfolio has declined from around 17% in 1981 to 11% in 1991 and 3%-4% today.
Given property's ability to offer both high income and capital growth, it is difficult not to conclude that the institutions will return to property. When they do, it is likely the additional premium of extra income over that available from fixed interest instruments will disappear.
This would mean we would have seen an increase in capital values to the benefit of existing investors.
One of the key positive developments of recent years is that imaginatively designed property products now offer the ability to participate in institutional quality investment at a modest level.
A number of product providers offer commercial property limited partnerships that acquire individual properties. These properties are likely to be let to high quality tenants for anything up to 20 years on leases without break clauses and upward-only rent reviews. Debt may fund anything up to 85% of the property purchase and, by fixing the level of interest rates for the lease period, a secure and stable investment can be created.
With investments starting at levels of around £25,000, and with an exempt unit trust feeder fund for Sipps and Ssas, private individuals' funds can achieve a portfolio of property investments at an affordable level.
Such limited partnerships are generally capital-growth-only investments. However, unauthorised unit trusts are also available, which provide a more diverse property investment strategy and offer daily liquidity.
Such trusts may invest in the higher yielding, secondary commercial property sector and may aim to distribute an income return of 6% or more per year.
Other products may offer the chance to invest in specialists sectors such as budget hotels, nursing homes and leisure clubs, offering even higher annual returns. The full spectrum of opportunity is becoming available across the entire property sector, with varying risk profiles and varying emphasis on capital growth or income. Several organisations are offering investors the scope to design their own tailor-made property portfolios at a level hitherto beyond the scope of all but the most substantial pension funds.
Many analysts are convinced we are entering a period of low inflation in which nominal returns will be much lower than in the past. At the same time, we have an ageing population, falling annuity yields and rapidly advancing life expectancy. Income must, therefore, become of increasing importance, along with the ability to retain the real value of investment funds.
Property meets these requirements as it offers a high yield which, unlike bonds, retains the ability to generate attractive capital growth as well. If the peak of the equity boom has been reached, a major beneficiary is likely to be the property sector.
Property element of pension funds is set to rise again from 3% level.
Gearing can provide an uplift in return in excess of 30%.
Income from gilts and equities has halved in the last 28 years while property yields have remained constant.
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