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Article 10 The outlook for commercial property in the UK
Thursday, 4th June 2009
UK commercial property has experienced the most severe downturn for over 20 years, driven by the contraction in credit and negative investor sentiment. As property is often a debt-backed business, the lack of available credit is effectively restraining investment and development activity in commercial property. In addition, we have seen a decrease in occupational demand for commercial property. This means the occupiers of buildings; be they industrial companies, financial services firms or otherwise, are scaling back their operations by limiting expansion and making staff redundant. Ultimately, less demand means prices have to fall to a level where demand is likely to increase again. This is being factored into property valuations and as a result our Pension Property Fund, and the broader market, have declined in value.
The asset class has suffered as a consequence of the unprecedented and on-going financial market turmoil and negative investor sentiment towards property. The continued stress in the lending markets and accelerated de-leveraging combined with further declines in capital values, weaker occupational demand, falling rents and increased risk of defaults have also seen UK commercial property plummet. Although we are not anticipating meaningful recovery until the latter part of 2010, the key focus for the year ahead is income preservation, management of voids and asset management. 2009 will continue to see upward pressure on yields, although we expect this to be concentrated in the first half of the year. Over the year we anticipate key markets, such as the UK, will attract investor interest again as prices more fully reflect downside risks. Our funds benefit from their depth and breadth of asset exposure across all the major property sub-sectors, with an emphasis on prime over secondary quality stock. We also continue to favour the retail and industrial sectors to offices.
The spread between the income yield on property and government bond yields (a proxy for the risk free rate) is a quick and easy metric used by investors to determine if property is good value. In the current environment, with long term bond yields massaged down via quantitative easing,, the spread of just over 4% is the highest it has ever been. This simple metric, however, takes no account of rental expectations, depreciation or the current lack of liquidity in markets. Investors are currently demanding a higher risk premium for investing in UK property, concerned as they are about the difficulties in trading and also because they anticipate a further hit to incomes as tenant demand wanes during a lengthy economic recession. Nevertheless, with prime UK properties now available for a higher income yield than some of the less well developed European markets, investors are recognising pockets of opportunity. A variety of triggers will herald an end to the current pricing correction and price stabilisation. We identify stability of fund outflows, improved credit availability, derivatives margins and investment volumes as being the most significant of these triggers. All of these indicators have remained exceptionally weak or trended weaker over the last two years.
UK property now provides an unprecedented yield over gilts, although there is likely to be a further challenging period ahead near-term for commercial property investors, resulting from the severity of the credit market problems, which have accentuated the on-going correction. With forward looking indicators signalling a more stable investment market, buying opportunities could appear in due course. The large number of capital raisings and interest expressed by private equity, sovereign wealth and opportunistic investors suggest equity rich investors also see value emerging. We anticipate improved liquidity towards the end of this year and firmly believe the Standard Life Pension Property fund is well positioned for recovery and attractive relative returns are expected in the medium to long term, primarily resulting from property’s stable income potential.
The Standard Life Pension Property Fund has return -11.3% since the beginning of the year to date, however, if you look at the fund's discrete monthly returns for 2009 a more positive view can be seen. The figures below suggest the pace of the decline in capital values of the underlying properties is slowing:
Pension Property Fund Performance (2009)
January: -3.7%
February: -2.9%
March: -2.3%
April: -2.0%
May: -0.9%
Source: Morningstar Workstation
