BACKGROUND
I remember the day well back in early July 2007 when it was reported in the newspapers that one or two of the large asset managers were reducing their allocation to this sector. This seemed to signal a 'rush for the door' by some private and institutional investors alike which was magnified by further unhealthy announcements in the papers later in the Summer around sub-prime debt in the US. UK & European banks in buying sub-prime packaged products, being high yield but high risk, were obviously exposed to a huge extent. The real consequence of this has been that the UK banks have become suspicious of lending to each other and anyone else for that matter.
As a consequence the 'real cost' of borrowing has risen, while paradoxically interest rates have fallen, having a negative implication for an asset class normally associated with gearing. In actual fact many of the funds that Pearson Jones recommend in this arena (being invested in bricks and mortar funds) are not borrowers, but the overall negative sentiment towards 'property' in general has been non-discriminatory.
I feel that another factor applies also, and that is the shorter term that many investors view their investments. This psychological change has probably been borne out of the wilder fluctuations the markets have demonstrated in recent times, no doubt as a result a greater level of information, delivered more quickly via the www and investors wanting to build timing into the equation to potentially embellish returns.
The relevance as far as Commercial Property is concerned is that many investors have enjoyed exceptional returns from this sector at a level widely viewed as unsustainable and whilst falls were never really predicted (more reduced positive returns) many saw the aforementioned reallocation in July as a signal to sell. This together with some of the other factors has magnified the problem.
It essentially becomes a ‘snowball effect’ with confidence rapidly eroding and perpetuating the problem whilst disguising the fact that the underlying fundamentals of the investments are still strong. Heavy requests to redeem are serious for funds investing in actual property, since it is by its very nature a very illiquid asset class. Being forced to sell to fund redemptions is the worst possible scenario. As a consequence, all the providers have reduced the selling price by about 6% (in an attempt to stem outflows), which is reflected in valuations, as well as some applying a six month moratorium on redemption requests. The independent valuations carried out on the underlying properties, typically every month, have been increased to fortnightly and these have reflected the reduced confidence in the market.
The last time this sector experienced falling values was in the early 90's but the underlying issues are very different. The following table illustrates this :-
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Early 90's
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NOW
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Inflation
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11%
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4.0%
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Interest rates
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15%
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5.5%
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Rental yields growth
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19%
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3.6%
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Vacancy rates
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15% (City of London)
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5.0%
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The figures above and other relevant data reveals the true nature of this asset class which is one that produces a highly predictable, long term income stream. As a reminder these funds purchase buildings across the UK and in the 3 main sub sectors of RETAIL, OFFICE and INDUSTRIAL. The buildings are typically valued in the many 10's of million of pounds, housing high grade tenants who sign up for leases of typically 10-20 years. Upward only rent reviews secure the level of income and as consequence these characteristics give the aforementioned predictable long term income stream. It is this feature that you are buying when investing here.
Recent outperformance has been generated by the appreciation in the perceived value of the buildings on top of the consistent income. On the other side of the coin, it is this element that has caused the recent falls which has largely been driven by sentiment. As the values become more appealing to the larger institutional and overseas investors then confidence and thus values will return. Much of this money is apparently poised to be invested but a 'wait and see' approach appears to be being applied.
I feel that the above will be the stimulus to this sector, and once apparent confidence returns, recovery could be swift. The UK Commercial Property sector is an attractive one to many of the major overseas investors since it is mature and regulated, unlike many overseas markets.
THE UNDERLYING FUNDAMENTALS OF THIS ASSET CLASS STILL HOLD STRONG ie LONG TERM INCOME.
Nothing has really changed in this regard and the asset class still represents a relevant investment in a well balanced, diversified portfolio. Remember it performs in a very different way to equities and bonds. From a risk point of view, it falls somewhere between bonds and equities and when held in a portfolio for the long term will prove to be a solid way of outperforming cash and inflation.
THE FUTURE
Confidence is the key as I have alluded to. The underlying fundamentals are still strong and the economy is in a very different position to that of the early 90's. Some dark clouds are around in the economy and could affect predictions but the general view is that things could get slightly worse in the first quarter of this year, with a recovery starting around the middle of 2008. 2009 looks more promising which in the context of a long term approach is not too far away.
At Pearson Jones we still feel very strongly that Commercial Property should be retained and held for the long term in diversified portfolios constructed from an asset allocation point of view.