The Market - So Pessimistic?
The August "Property Holiday" started early this year - June or July or even earlier, depending how one measures these things. With very few transactions taking place in the market, many surveyors have decided that they have little to lose by taking a holiday or two around this time.
This attitude is a reflection of the general air of pessimism which seems to have gripped the property market - although the equities market appears rather immune, managing to achieve new and almost record highs for the year. In as much as the property market believes that the future is an extrapolation of the past, the fact that Hillier Parker's indices show that rental value growth over the past couple of years has only been barely positive will be, for some, good enough reason for pessimism. Compounding this perception is the fact that the Hillier Parker Rent Index relates to broadly-prime property, and the figures actually show some of the market's best performance; secondary property has fared worse in most cases.
When one compares these figures with the experiences of the growth phase of the late 1980s (within recent memory for most property people), they look quite meagre. Of course, one needs to be very careful not to be overly influenced by historic nominal performance. With inflation running at an average of over 8% over the last 30 years, high nominal growth was required just to maintain real values. In the lower-inflationary environment of today, 5% or 6% rental value growth is actually very attractive.
Nevertheless, there is a range of more complex reasons for this pessimism, which, of course, makes it all the more real. We have discussed some of these in previous commentaries, but we thought it would be useful to collect them together and to test their reasonableness. (The italicised text represents the case for a "pessimistic" view, whilst the text following represents our arguments and conclusions on the point.)
It is now some three years since the end of the recession, but there is, as yet, little evidence of rental value growth in office and industrial property. On the contrary, the rationalisation and merger activity, coupled with the drive for personal efficiency, has apparently led to a corporate need for less space. We have previously heard claims that the growth is just around the corner, but why should it happen in, say, the next year?
The recession witnessed an early shedding of "excess" labour in contrast with previous recessions, when employers tended to hoard their more valuable workers in anticipation of the recovery phase in their case, it has continued during the recovery (another unusual aspect). Nevertheless, the numbers in employment have been rising since the end of the recession - admittedly in a very volatile manner - but, nevertheless rising. Two distinct forces are at work here, nevertheless larger firms have been able to increase production by better management, which often involves further redundancies; whilst smaller firms have provided a large proportion of the new jobs. This reflects the differing abilities of the two groups to respond to the changing environment, but also gives a clue as to why the former have become relatively more profitable. It is also worth acknowledging that the notices of company rationalisation and expansion plans which are reported in the national press will tend to relate to the larger companies, merely because the individual numbers of workers involved tend to be bigger. In contrast, the growth in the numbers employed in the smaller companies usually goes unreported.
Overall, the profitability of industrial and commercial companies has been rising since 1990, and, excluding companies involved in the development of new oil fields, their real rate of return on capital is now around 9.5%; close to the late 1980s peak of just over 10%. Admittedly, we have seen a fall in the first quarter of 1995, primarily due to the domestic down-turn.
In any event, this down-turn may be taken as a signal to the corporate sector that there is a limit to the gains which can be obtained from the process of rationalisations (the law of diminishing returns).
Even if we are not quite yet at the turning point, we believe that further improvements in productivity are likely to be very difficult to secure without increases in investment. Investment has been relatively poor in the post-recession period but there are signs that this is set to improve. While the latest CBI survey confirms that manufacturing output is slowing and confidence falling, a higher proportion of firms intend to invest in plant and machinery than at any time since April 1989. The same survey indicates that export orders continue to increase rapidly and, indeed, work by JP Morgan suggests that the profit margins on exports are now greater than on domestically-consumed output.
Increasingly, companies are approaching their output capacity levels. They are faced with two choices. They can raise their prices to improve their profit margins, but accept the probability that their share of trade will decline. Alternatively, they can expand and either maintain or increase their share of the market. Clearly, the recent wave of mergers and take-overs indicates that many companies believe that their future lies in becoming bigger. Opportunities to grow by such means are, however, obviously declining and they will soon have no choice but to grow organically.
Evidence that organic growth is an attractive alternative is emanating from the US. Having been through a period of corporate re-engineering, which has become associated with corporate anorexia, there is now an apparent desire to revitalise companies by growing and expanding their activities.
Although there is no conclusive evidence that such ideas will be adopted by UK companies, ideas nevertheless spread quickly in a competitive global marketplace.
Companies already have the means - their financial surplus as a proportion of income is at its highest level since 1972. They have the need - more industrial companies are expecting capacity constraints to limit their output. But what they are lacking is the confidence - they are worried about whether the current recovery will continue.
There are probably two main reasons for these worries. Firstly, there is declining domestic demand which is affecting not just retailers, but also manufacturers and providers of services. Secondly, there is political uncertainty with the possibility of a change of government at the next Election and, in the interim, uncertainty as to whether or not interest rates will rise. At least the interest rate question will be resolved in the next few months, and assuming that the budget is marginally reflationary, domestic demand is also expected to improve.
None of the above provides conclusive evidence that companies are going to embark on a period of expansion starting in 1996, or that it will impact on property requirements so as to generate rental value growth. But we believe there is a strong convergence of factors suggesting that this is a necessary next phase. Many economists are forecasting strong growth in fixed investment by the end of 1995 and into 1996. Larger companies in particular are competing on a global scale and they will need to grow in absolute terms if they are not to shrink in relative terms. This will mean investing further in new technology, employing additional staff, and taking additional space. We believe that much of the pessimism relating to demand for business space is merely a hang-over from the last few years.
Certainly, there is little reason for investors to feel worried about the medium-term prospects for growth. With property yields closer to gilt yields than in any previously recorded growth phase and, on the basis of fundamentals, property is not over-priced.
The improved efficiency, referred to above, suggests that we can produce more from less: more output from less workers and less space. Maybe we need to accept that, as a nation, unemployment will stay permanently high and therefore, less working space will be required.
Every form of "revolution" that an economy goes through inevitably results in a new wave of unemployment. Yet, provided the value of goods produced either remains unchanged or increases (which is, of course why such improvements occur), there will be additional monetary returns provided to those still in employment and/or the companies for whom they are working. These additional returns will flow through in terms of dividends, or salaries, and be used for additional investment or consumption. In either case, more output would be called for and there to be a multiplier effect as additional capacity is added to the economy (ignoring imports).
Of course, some of the old jobs will no longer need to be done and some of the new jobs will require new skills and training. There will be a transition as the economy adjusts but, overall, standards of living will increase. This is progress.
The important thing to realise is that even if we are wrong in the timing of our forecast, nothing has fundamentally changed about occupiers' need for property. Low inflation may imply low nominal rental value growth, but it says nothing about real rental value growth. British industry is now better placed than at probably any time during the last 30 years to expand into a period of sustainable growth; it is better structured, and managed, the workers are more efficient, and it is highly competitive. New technology may have taken away some jobs, but it is giving us other jobs - in data processing, communications, and the media.
A number of institutions decided in the early part of 1995 to reduce their property holdings (and increase their equity holdings) and that decision has proved to be the right one. Hillier Parker is forecasting total returns from property to be about 3% this year, in contrast to the double digit returns expected from equities and gilts. Investment property is clearly out of favour. The Pensions Bill will make it less attractive for pension funds to hold property because of its poor liquidity, and property companies are unable to raise new equity on the Stock Market. Where will the buyers come from?
For most of the past year, we have been advising our clients to be underweight in property. Now, however, because we believe its prospects are better than at any time during the past few years, we are now starting to recommend the opposite.
In the short-term, the number of institutions seeking to re-weight will have a somewhat depressive effect on the market as, in some cases, they are virtually 'forced sellers'. We therefore expect to see some further small falls in value in all but the prime end of the market. But by the end of the year, we expect the situation to stabilise.
The recovery in confidence will be slow. This is primarily because the market was misled by the dramatic fall in gilt yields in the 1993/94 period, which somehow became translated into an optimistic view about the occupational demand for property. What we are now seeing is the reaction to that, and it will take some time before confidence can again be restored. Nevertheless, as we move into 1996 and if as we expect, rents are then clearly seen to be rising, then the investment market will respond accordingly.
Issues such as liquidity, whilst very important in their own right, quickly become brushed aside when good performance is expected. With a typical portfolio yield of around 8%, it requires only a small amount of rental value growth, and/or favourable yield movement, to produce double digit returns. In contrast, equities are probably approaching the peak of their cycle, with the expected earnings and profit growth already reflected in their prices.
It is a fact well-known to fund managers that retail monies can be readily raised amount when growth is evident, and we expect that it will not be long before funds and property companies are able to tap the equity capital markets once more. Of course, the banks have never really disappeared from the scene and debt finance will also be readily available.
Perhaps more importantly, the institutions have shown themselves to be capable of making switches between asset classes when performance expectations change. The period between 1993 and 1994 is a good example - the fact that the justification for increasing investment in property at that time was the yield (relative to gilts), does not alter the fundamental argument that investment will be attracted to those markets which are expected to perform best.
Consumer expenditure actually fell in the first quarter of 1995, and retail sales remain very depressed - and have grown by only 1.1% during the year. By coincidence, the Hillier Parker Rent Index has risen by almost the same amount (1%) over the year to August, although most of that marginal growth occurred in the latter half of 1994. There is no doubt that poor confidence in the personal sector is affecting retailers and this, in turn, is affecting demand for retail property.
While we continue to be more pessimistic about the retail sector than the others, it is likely that it has reached its lowest point for this cycle. Although Kenneth Clarke may be more cautious in his tax giveaways in the November Budget than many Conservative back-benchers would like, it is nevertheless inevitable that some concessions will be made. If the concessions are structured in a sophisticated way, the Chancellor may be able to improve domestic confidence without significantly reducing the tax take. In any event, we are expecting the Budget to result in an improvement in consumer expenditure and retail sales in the pre-election period.
Even so, it would be a mistake to believe that this boost to the retail sector would be a pre-cursor to stronger growth in the future. It is almost inevitable, whichever party takes control at the General Election, that interest rates are maintained at such a level as to restrain future consumption. Unfortunately, the current structure of the retail industry - occupying prime (expense) locations and maintaining large numbers of under-utilised staff at the point of sale means that it is badly placed to deal with a cost-conscious consumer.
Of all the sectors, it is the office sector which has demonstrated rental value growth over the past year. The growth has been sporadic and focused on particular locations; nevertheless, it has been strong enough to feature in the overall index. However, because of the location-specific nature of the evidence, the recovery in this sector will not be globally recognised as early as it might otherwise have been.
The sector's demand characteristics differ considerably from retail inasmuch as a decision to relocate from office space is normally taken well in advance of identifying suitable accommodation. This means, in effect, that commitments to acquire new space may be made, but they take sometime to become evident to the market. Moreover, a diminishing supply may bring forward this demand. In other words, the fact that some lettings are occurring can engender increased activity, as companies become increasingly concerned that their plans might be frustrated. The result is that the market can rapidly switch from one of over-supply, to one of under-supply. Investors will need to be sensitive to the increasing probability of these changes in the short to - medium-term.
Inevitably, some locations are going to be suffering from a shortage of prime-quality space, and good-quality secondary accommodation will provide a good substitute. In some instances, in fact, some of the 'second-hand' space can be of superior quality. We do not, however, envisage that this demand will filter down to the secondary end of the market, except where such space is suitable for occupation by small businesses. As we have suggested before, large businesses will primarily be concerned with the efficiency of the space, and reduced property costs will not be so significant a benefit as to compensate for ineffective accommodation.
In 1994, manufacturing output grew strongly, but the first quarter of this year saw a sharp down-turn. This can largely be attributed to poorer domestic demand, as exports continue to grow apace. Even the down-turn in manufacturing output may turn out to be more illusory than real - the CBI industrial-trend survey published on 25th July paints a contrasting picture; although confidence has declined, expectations of manufacturing output are still stronger than they were, say, a year ago.
There is an argument that profit margins on exports are now at a higher level than they have been for a long time (including the 1980s) and exporting companies have therefore been accumulating large reserves of retained earnings. If this is correct, these companies are in a very strong position indeed, having both cash and profitable earnings to invest, and grow further. Obviously we will monitor this position to see whether the evidence supports the argument. If so, we can afford to be more optimistic about industrial property's performance, but we would need to add two caveats.
Firstly, a large proportion of (particularly smaller) industrial units are used for quasi-retail and service purpose and these occupiers are probably still feeling pressure on their profit margins. Second, even those who are manufacturing goods may not be exporting them - again, this applies particularly to smaller companies. Any benefits are therefore likely to accrue to larger industrial units in locations which are strategically important for export trade.
For further information please call Alan Patterson on 0171 629 7666, extension 2376 or write to him at Hillier Parker, 77 Grosvenor Street, London, W1A 2BT.
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