18/01/2010
Commercial property in the UK has fallen more quickly in terms of demand and fallen further in value than has been experienced in any other developed country in the world, in the last 24 months.
So if you buy in 2010 are you just trying to catch a falling star or perfectly timing the bottom of a cyclical market?
The signs are there that the market is improving as prices for institutional quality buildings let to strong covenants have risen sharply in the last four months. In some cases yields have compressed by in excess of 200 basis points. But are the principle drivers sustainable or simply a response to the very thin trading volumes that characterise the current market?
As always pricing is driven by the levels of supply and demand. For the last year the supply of investments for sale has been very significantly less than historic levels. There are many reasons why supply is restricted. Most owners expect the market to recover so are understandably reluctant to sell at what may be the bottom of the market. In many cases investors borrowed around 70% of the purchase price and values have fallen by more than that, so there is no benefit to them in selling. As there is so little property in the market, investors are concerned that if they sell they will be unable to replace the income stream. There is also the issue of what should they do with the money if they don’t reinvest; what other asset class offers similar potential returns?
Demand for commercial property was at it’s lowest in the spring of last year, at which time a number of ‘fire sales’ were being quietly agreed by investors seeking to raise cash and pay down debt. Since then, as confidence has slowly returned, the market has risen for the better quality investments, and vendors have started taking a slightly tougher line. Strong institutional demand for those properties let to financially sound tenants returned in the Autumn of 2009. Supply was limited and the majority of the institutions returned to the market at the same time resulting in a supply demand in-balance that forced prices up dramatically over a three month period.
The year ahead is uncertain. Investors are reliant upon occupiers requiring space and being able to pay the rent. Whilst fears as to the number of future insolvencies have reduced slightly, the global outlook remains cautious. Companies rarely seek to expand and thereby drive the demand that leads to rental growth in an uncertain economic environment.
Property investments can provide secure long term income streams in sectors that are continuing to experience growth. Supermarkets typically sign long leases and provide strong covenants thus providing what is perceived to be a secure income stream in a growth sector.
Some towns have significant oversupply of office space giving occupiers a huge choice and creating competition amongst landlords that is driving rental levels down. Should you buy a building in the wrong location and be unfortunate enough to loose the tenant then the liability for the building costs will revert to you and potentially the void period could be years rather than months. On the other hand there are locations where office supply is still restricted and thus the risks of loosing a tenant and incurring all the associated costs are minimal.
The other side of the equation is the yield that will be applied, which directly impacts on capital values. In the next six months it appears likely that yields for strong covenants in quality buildings, but with perhaps shorter income streams, may well experience yield compression driving up prices as institutional investors are forced to seek a compromise in terms of the income profile. Beyond the next six months we suspect that we will experience a period of price stagnation, unless another world event or strong inflation provides a catalyst for a further market change.
The balance of risk and reward for potential investors is difficult to quantify in today’s market – the Investment team at Vail Williams have the expertise and knowledge of the market to help businesses and individual investors get the right balance. Income returns from commercial property currently range from 5.5% to in excess of 13% pa and the risk profile of the investment generally rises with the yield. This sort of income stream is difficult to generate from other asset classes. Returns can be further enhanced and in some cases doubled by borrowing part of the purchase price but we would caution that not many banks are currently seeking to grow their loan books.
Finally we should mention the possibility of occupiers buying their own building. Provided their bank is prepared to fund them and they don’t have a very long lease it is likely a company’s rent / interest payments would fall and potentially halve, if they bought the freehold of the building they occupy. Whilst this isn’t always the case, if you are part of a company’s senior management and wish to stabilize your occupational cost base, 2010 could be an exceptionally good year to do so.
