Low interest rates and the lack of speculative development suggest the outlook for the commercial and residential property sectors should remain attractive in the coming months
Prospects for the residential property market may be much the same as for commercial property but there is no direct correlation between the two. Residential property is driven by owner occupiers although private investors have clearly influenced market activity in recent years.
The market is being supported by the fact we are still building too few homes. New building is currently at around the same level it was in 1924 despite an increase in population of about a third since then.
Demographic and social trends mean there are more divorces, less marriages and longer life expectancy, with the result that more household units are needed. Meanwhile, fashion has moved away from the traditional terraced house to the spacious flat. Population migration from north to south also means surplus houses are not in the locations of greatest demand. Affordability must in due course temper price inflation but, in the absence of interest rate hikes, it is unlikely we will see a collapse or market freeze as occurred 12 years ago.
Commercial property has outperformed UK equities for the past 15 years, a period that includes the 1990-1993 property slump, the worst since the last war. This begs two questions: Is the commercial property party now over? Or, even worse, is property about to experience another collapse?
From an analytical standpoint, the fundamentals look very strong. Property is offering an exceptionally high income at a time when income is seen as an increasingly important element of total return. As this exceptionally high income is available at a time when interest rates are at their lowest for nearly 50 years, returns look even more impressive.
Geared income returns ' the income achieved after borrowing part of the investment cost ' is often more than 12%. Real returns of 8%-10% after costs were unheard of during the inflationary rollercoaster decades of the 1970s, 1980s or 1990s. Unless property's capital values suffer, the asset class may continue to outperform equities for some years to come.
The prospects for commercial property values are inextricably linked to the fortunes of the economy. Financial services and manufacturing are taking the brunt of the current economic slowdown. Areas most exposed to these sectors are bound to suffer worst, so rents in the City of London may fall by as much as 20%.
In the short term, it will not be the property funds owning property with long leases and upward-only rent reviews that suffer but lessees subletting surplus space, along with any speculative developers ' those developing without having pre-let their space before construction.
Owners with vacant buildings or owning property at the tail end of leases will also be penalised. If the market recovers over the next five years, investors may not be significantly influenced as long as their tenants survive.
Outside these areas, prospects look better. Cities that saw substantial development in the 1960s such as Birmingham, Bristol and Leeds now have excess semi-obsolete office blocks with demand for new quality space likely to remain strong.
Most significant, however, is the absence of the two principal shocks that tipped property into recession in 1990. The late 1980s saw a massive increase in speculative development that resulted in a big increase in supply just when demand evaporated. This has not been repeated.
The main shock that traumatised the property markets in 1990 was an interest rate that rose to 15%. Current low interest rates are most unlikely to contribute to the same levels of distressed sales as developed 12 years ago.
Overall, property investors can expect satisfactory returns from the rental income and perhaps unexciting capital growth. By comparison with equities, that is not a bad picture.
However, better returns can be achieved by concentrating on small niches in the property market, where a fund can operate with competitive advantage. Alternatively, leases of up to 25 years secured by upward-only rent reviews and solid tenants can buy a level of security that is a rare commodity at present.
Elsewhere active management funds as opposed to large property portfolio funds may generate capital growth even in flat market conditions.
Close Property Investment, part of Close Brothers Group plc, has syndicated a number of new developments where leases of up to 25 years have been agreed to provide investors (in investments units of £25,000) with the opportunity to invest in an income stream that should protect them over a number of economic cycles. These have generally been structured as capital-growth vehicles taking maximum opportunity of low interest rates to fund 80% or more of the purchase cost.
It is important to have a variety of ways of getting exposure to the property market so investors can pick the one that suits them best. We offer different funds that suit different economic conditions and investors. One of our funds capitalises on buoyant market conditions. It buys empty flats in retirement homes, which it refurbishes and then offers on lifetime tenancies to occupants in their mid-70s.
The lifetime tenancy sale recovers two-thirds of the purchase outlay, which means the fund will achieve 300% property appreciation when it recovers vacant possession in around 10 years, assuming no property growth.
The recycling of lifetime tenancy proceeds into further acquisitions and means the fund achieves 250% operational gearing without borrowing. This means a 10% benefit to the fund for every 4% growth in residential property values.
We have another fund that invests in high-yielding offices, shops and industrial property where after borrowing 60% of the purchase cost geared income of around 12.5% can be achieved. Properties acquired will be those that, by means of lease extensions, refurbishments, rent reviews or lease renewals, can offer capital growth above average market trends over a three to five-year period. This fund has a 10% total return target of which 6% can be distributed in the form of income.
We offer a fund that owns around 40,000 freeholds under blocks of flats and houses with an income stream of up to 999 years. Funds like these can offer decent yields and the prospect of consistent growth.
Another of the funds we offer finances new hotel, specialist care home and leisure developments with experienced operators. Loan notes provide the income, while after three to five years, the sale of a 50% equity share in the developments provides an equity kicker.
This type of fund can offer the ability to achieve an income similar to a rental yield whilst also enabling the investor to participate in the value of the business operating within the building.
Low interest rates are helping ensure the property market will not be tipped into recession as occurred in the early 1990s.
Different types of fund are suitable for different investors and different market conditions.
Outside London, commercial property looks set to benefit from demand for new office space.
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From 6 April 2019
Marcus Brookes appointed CIO