Commercial property is having a strong run but it is still worth investors putting it into portfolio...
Commercial property is having a strong run but it is still worth investors putting it into portfolios because it acts as a diversifier and much of its total return comes from income. That was the view of Philip Gadsden, head of external funds at Insight Investment, in a speech to delegates which also covered the future prospects for the asset class.
He said: "Commercial property is an income-orientated asset class that does produce capital growth. If you put property into a portfolio comprising equities and bonds, it really does diversify risk and can improve returns. It is a good asset class in that sense. The quality of the income is spread around a large number of tenants on long leases. Typically you'd expect in a portfolio to have an average unexpired term of nine to 10 years."
Figures from IPD, FTSE and Barclays Capital suggest that during the period 1980-2004 property had a 0.13 correlation with the FTSE All-Share and -0.08 correlation with 5-15 year gilts. Over the same period equities had a correlation of 0.35 with gilts.
Gadsden suggested that, historically, adding property to a portfolio has not only reduced volatility but has also ensured total returns rise as well. Over one, three, five and 10 years to 2004 a portfolio split equally between equities and bonds, has produced higher returns the more property is added to it, up to a level of 33%. Over the total period 1980-2004 this trend does not work, with the returns falling the higher the property weighting, although there was very little difference between the total returns generated (see graph).
"That's not to say that you should put 100% in property, but perhaps you should think about putting in more than 0%," said Gadsden.
Insight Investment's head of external funds then turned to the question of whether or not the asset class is overpriced. According to Gadsden, the IPD index still offers a healthy yield premium relative to gilts, whereas back in the late-1980s the yield on Government stock was higher than on property. He said: "Back then property needed to perform strongly to match gilts but now the income yield is ahead of gilts, never mind any capital growth you get on top.
"From a personal point of view, property is certainly more expensive than it was a couple of years ago or so, but is it too expensive? Well, it rather depends on what you are hoping to achieve with your portfolio. On the whole, I think it's about fairly priced currently."
On the other hand yields across the commercial property market are coming down, from around 7% two years ago to 5.5% at present. "A large part of the return from property over the last year or two has come from capital growth. Clearly that's unsustainable over the longer period," he said. "But the interesting thing to note is that there has been a re-emergence of rental growth around the country. It's not happening everywhere but there is definitely a positive move."
"In offices, rental growth has been a real rollercoaster ride. The interesting thing is that it is beginning to go positive again. Offices are probably the sector where we think there are going to be the best returns over the next few years."
Gadsden said investors need to get their timing right when it comes to the subsectors of the commercial property market. He added: "In the early part of this century, you didn't want to be anywhere near offices. Industrial is a rather different picture. It's more of an income-orientated sector. It produces a little bit of rental growth, and we like it for its income characteristics. Retail will be less good over the next few years.
"Reasonably good levels of rental growth over the next few years will drive total returns of this sort of order: in 2004, total returns were 18% or 19%; 2005 is likely to come in around mid-teens territory but thereafter this yield compression which has driven up returns will begin to slow down. We think the total returns in the market are likely to be in the 7%-9% range. It's not close to 15% or even 19%. But 7%-9% is not bad with inflation where it is."
Commercial property has three subsectors: retail, offices and industrial. Retail is high street, out of town parks, shopping centres and leisure; offices can be divided into City, West End and regional; industrial consists of High Bay and Estates, generally not heavy manufacturing.
Commercial property is not PFI or PPP, schools, churches, golf courses or residential property.
The UK commercial property market has investable universe of £265bn and has produced 12% a year returns in each of the last five years.
The sector offers portfolio diversification, security of income and low volatility.
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