The Outlook for Property
As we approach the end of the year, it is fairly certain that this will have been another disappointing one for property. That is, of course, unless the equity market experiences a sudden drop - something which would not be too much of a surprise given the increased economic, political and monetary risks that the market is facing, not forgetting the potential for a knock-on effect from problems in the USA and Continental Europe. In practice, however, the equity market is not likely to want to think about these too much before the new year, and any fall is more likely to occur then than now.
The disappointment is a relative one. Property, which we expect to produce some 9 to 10% total returns, will have significantly under-performed equities and even gilts, but it will have out-performed cash. This is a bit of relief from last year, when it only produced 3.2% (according to the IPD annual index).Our forecast suggests that property capital values increased marginally over the year (having started the year by falling) and this, we believe, represents a real turning point in the market - unlike the artificial one at the end of 1993. The turn has come somewhat more gradually and even somewhat later than we expected, and this reflects two things.
Firstly, a degree of caution in the direct property market. The talk, in the early part of the year, of an increased institutional allocation of money shows that it is not only agents who are capable of hyperbole. There may have been money available, but there was apparently no pressure to invest it. As the year unfolded, surveys indicated a continuing deferral of net investment intentions, which now appear to have been rolled into next year. Over the year, the yields for the better quality growth stock, as measured by Hillier Parker Average Yields, have been static or rising. There is, apparently, a muted retreat to the income stock - which provides the certainty of income but at the risk of a lack of exposure to a recovering market. Given the continuing improvements in the occupational market, as evidenced by rising rental values and falling incentive packages, this is a strange phenomenon (which I will return to later in this section).
The second reason is the effect that economic and physical obsolescence is having on the property stock. The 1980s "Big Bang" brought with it a realisation that the then available property could not meet the requirements of such an era; fortunately, the economics of growth enabled the viability of development (and more importantly, redevelopment) to come to the rescue. The post-recession is an era with its own requirements, but not the means to meet them. Property owners are stuck with much obsolescent properties. In other markets, the problem would have been dealt with by write-downs or even write-offs, but the inertia of the property market has limited the movements in value. An unwillingness to face such harsh realities will, like in the Japanese economy, make the recovery slow and faltering. This translates into lower returns and higher risk
This all sounds very pessimistic and, indeed, it is suggesting a scenario which is too pessimistic for anything other than the short-term. The lack of confidence is born out of years of property's under-performance. Confidence is very much a circular argument, but can be quickly triggered into a new circle. Peculiar as it may seem to suggest, one of the obvious stimulants to commercial property confidence may be the residential market. It was only a year ago when most "forecasters" were talking about modest growth for residential property, whereas there is now an expectation of around 6% for this year. The fact that collapsing residential property prices had preceded those of the commercial market (with other similarities in rates and geographic components) and that they are preceding them in recovering will not, for instance, go unnoticed by lay trustees.
Performance worries have not prevented investors from trading; the volume of institutional investment activity has been increasing from it low of 1995. Indeed, it might be argued that such concerns were the prime motivator behind the desire to restructure portfolios. In our discussions with investors, they expound a range of views, some very strongly-held, about which types of property are going to do well or badly. Issues such as high/low yielding, retail/office, and development are the most prominent dividers, but there are also more subtle matters. Over the year, survey results show changing positions, presumably as a result of pricing/demand and economic/financial news; the most notable has been a desire to reduce weightings in Central London offices.
The effects of polarisation are more evident in this economic cycle than in any previous modern growth phase. The gap between the best and the worst paid is higher than it was in Victorian times, whilst the gap between the well-run and the poorly-run (or unfortunate) companies is being magnified. The property market has been slow to respond, perhaps because it does not fully understand the changes which are happening.
Worse than that, the perception of relatively generally poor rental value growth has focused attention on improving portfolio yield in the short-term, even as the prospects for rental value growth continue to improve. Such perverse behaviour is not confined to the property market - it is not unusual to find confidence waning immediately before an objective is achieved in many other walks of life.
The prospects for rental value growth remain have improved for retail in the short-term. Consumer confidence is rising and reflected in strengthened retail sales growth - something that was not happening a year ago. This sector's performance peak is, however, likely to be fairly short-lived as the Government moves to contain consumer expenditure.
The service sector is also growing strongly and, despite the headlined redundancy announcements, employment in this sector is increasing dramatically. Oversupply remains a problem, and we should expect to see increasing price differentials causing the "average" office property's growth to be limited. Industrial property is facing a more difficult time, particularly outside the South-East, where there is a greater dependence on manufacturing for occupation. The self-enforced inability of Continental Europe to provide a stimulus (to qualify for EMU) to their economies, and the stronger pound (reducing export profit margins), together with exceptionally high levels of domestic stock, combine to restrict growth in this sector. The problem is not so great in the South, where economic growth is strongest (we are seeing the north-south divide reasserting itself) and its stronger growth will filter through the market to a much greater extent than in the rest of the country.
Property is only another asset class and its expected returns need to be compared with those of equities and bonds. The former of these has performed well on the back of rising corporate earnings growth (although the growth has possibly been over-stated) and such growth is not likely to be sustained for more than a year or so. Gilts will suffer from continuing political uncertainty, although there is probably much upside potential - particularly if the UK does not initially join EMU and it does not work out quite as expected.
Property is not, however, without its short and medium term risks. One is that the economy will move into a new recession. This is not likely in view of the fine-tuning which is currently being applied. The bigger risk is that growth will be anticipated to be becoming too strong and interest rates will rise faster than previously expected; this will adversely affect property because of its high capital requirement and the growing amount of development.
The big medium-term advantage for property will be the planning scenario. The restrictive environment of the 1970s was probably the biggest single factor facilitating the rental value growth of that era. The late 1990s hold the promise of an even more restrictive period. Not only is there little government finance available for new road schemes, but the population does not, in general, want any more. This is part of a wider change of sentiment, away from growth at any price, towards a concern about the social and physical environment. Job insecurity may be a worry, but people do not seem convinced that growth is a solution to this.
Restrictions on green-field (for which one might read out-of-town) development will encourage more costly brown-field schemes. These costs will be borne by the corporate sector, but will impact positively on the property investment market by tightening supply.
Written by Alan Patterson
For further information, contact: Alan Patterson, Head of Investment Research, Tel: +44 (0) 171 629 7666, Fax: +44 (0) 171 409 3016