Building returns from commercial property

Capital values have recovered 17.05 per cent from their lows and are 35 per cent below their 2007 peak. However, within this recovery there is enormous variation between prime properties, which have seen capital values recover sharply, as evidenced by the 38 per cent increase in the CB Richard Ellis Prime Central London index, and secondary properties, where continuing uncertainty about rental levels and tenant demand have held prices flat.

In the UK, the split between the regions and the South East is marked. Take up in the Leeds office market, for example, is usually 450-600,000ft2 (42,000-56,000m2) per annum, but is currently half that level. High vacancy ratios are putting rents and rent-free periods under pressure in provincial cities and towns, in contrast to London, where demand for prime office space is outstripping supply and the development pipeline has almost seized up.

“Finding good quality office space in the West End is becoming more difficult as supply reduces,” says James Thornton, fund director at Mayfair Capital Investment Management. “Rents are pushing back up quite rapidly and the incentive packages are getting poorer. Instead of 12 months rent-free in a five-year package, we’re now looking at six to seven months. The development on the corner of Bruton and New Bond Street is an example – rent there was £75-£80ft2 (E84-E89) a year ago, and is now up at £90,” he explains.

“In the regions, the private sector is not robust enough to take the place of lost public sector jobs and real incomes are decreasing as people don’t have the ability to remortgage and house prices are not going up. In London, low sterling is also boosting demand from overseas – last year, 69 different nationalities purchased commercial property in London, which demonstrates the breadth of those interested,” says Mr Thornton.

“Jones Lang LaSalle has identified over £50bn invested in London from overseas – it is a safe location and also benefiting from unrest in the Middle East. Anecdotally, investors in Egypt, Yemen, and Bahrain are looking to move outside of those countries and London is a beneficiary. We’ve heard from bankers at RBS and Barclays that there is significant inflows of cash into accounts from these places.”

Although much grade A property has already been rebranded and stabilised, some properties are still 25-30 per cent below their peak two and a half to three years ago. This presents good opportunities for investors who can bridge the funding gap and buy property at attractive prices in these stretched or distressed situations.

“Companies have been improving their balance sheets and the rights issues undertaken by many in the downturn have subsequently left them in a strong position,” says Guy Barnard, fund manager, property equities at Henderson.

“The average gearing of a listed real estate company is 40 per cent in Europe, 45 per cent in the US, 30 per cent in Asia Pacific – these loan to value ratios are very much in line with the average for these listed sectors over the last 10 years – and will enable them to take advantage of deals coming into the market as a result of pressure from the banks. The Reit (real estate investment trust) sector is looking to take advantage of forced sellers, and this should be a real opportunity to grow market share.”

Niche investment groups can sometimes step in where developers are looking for cash, filling the gap left by the banks by investing in preferred equity with profit participation, particularly residential development projects in London.

“Large funds are not able to invest enough money in this sector to make a difference,” says James Lloyd, director of marketing and business development at Mayfair Capital Investment Management. “Smaller funds can move more quickly – family offices and smaller institutions are also looking at this gap.”

The UK listed real estate sector is particularly well positioned in the retail sector, where size and muscle is increasingly important.

“UK retail accounts for 67 per cent of investment exposure for the UK large cap Reits such as Land Securities, British Land, Hammerson and Capital Shopping, and is concentrated towards dominant regional shopping centres – the large cap Reits own stakes in 15 of the UK’s 25 largest shopping centres – and out of town,” says Michael Burt head of real estate research at Portugese bank, Espirito Santo.

“Average occupancy across the peer group’s retail portfolios is currently running at 97 per cent, suggesting that some degree of price tension is capable of being maintained in spite of a modest demand outlook. Unfulfilled demand from John Lewis and Debenhams for new anchor stores also represents a pre-letting opportunity for the Reits’ development pipelines. Land Securities has already confirmed the go-ahead for schemes at Trinity Leeds (65 per cent let or under offer) and the Atlas site in Glasgow and both Hammerson (Eastgate) and Capital Shopping Centres (Victoria Centre, Lakeside) have material potential schemes in their pipelines,” says Mr Burt.

“The mid and small cap end of the sector also offers the opportunity to exploit the unsatisfied demand of the UK supermarkets. Specialist retail vehicles LXB Retail, Metric Property and NewRiver as well as developers Helical Bar and Terrace Hill, all have either current or proposed pipeline schemes built around supermarket anchors.”

US Reits are also in a strong position to make acquisitions, with a cost of capital advantage, which will accelerate earnings growth. Last year US Reits expanded their net portfolio value by 6 per cent through acquisitions.

“In the US, Reits are generally specialists, focusing on just one sector such as retail, office, healthcare or student accommodation,” says Henderson’s Mr Barnard, who holds 50 per cent in the US – a 3 per cent overweight. “They have maintained occupancy levels during the downturn and, now fundamentals are improving, offer attractive earnings and dividend growth prospects. All else being equal, we expect 10 per cent dividend growth per annum in the years ahead, on top of a 4 per cent starting dividend.”

Real estate in developing economies continues to be driven by urbanisation, industrialisation, population growth and liquidity, but while valuations in growth markets are attractive, investors are nervous and tend to pull out of the market rather freely. Several fund managers say they prefer to focus on the office market in Hong Kong, which enjoyed 30 per cent rental growth in 2010 and will not have significant new supply in the immediate future.

Ben Habib, CEO of the European specialist First Property Group, believes central Europe has advantages over the UK market, and favours retail properties in Poland because disposable income per capita is rising fast. “We are able to buy well-let assets at yields some 30 per cent wider than in developed markets such as the UK, let off substantially lower rents,” he says.

“When the two are combined the capital valuation differential is stark. We are sourcing properties to buy at present that should comfortably generate a moderately geared mid teen annual income return in year one, with the expectation of rental growth and capital value gain beyond that.”

Fund managers are also bullish about the healthcare and data centre sectors. Folmer Pietersma, fund manager at Robeco, holds Digital Realty Trust, for example, which develops and operates data centres for telecom and internet companies. The underlying drivers in these two sectors are less correlated to the economy and will enjoy growing demand.

In the US, the strongest performers last year were hotels and apartments, which positively benefit from difficulties in the residential home purchase market.