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The Actuary The magazine of the Institute & Faculty of Actuaries

Raising the roof

Commercial property has enjoyed very strong investment returns over the last five years and has outperformed the equity and gilt markets over the last 3, 5, and 10 years. However, it is still considered by most institutional investors as no more than an alternative asset class.

Investment trends
Although the last 18 months have witnessed increasing levels of demand for investment-grade property, institutions have been cautious about increasing their exposure to the sector. The series entitled ‘Investment by insurance companies, pension funds and trusts’, issued by National Statistics, indicates that UK institutions have been net sellers of UK property in the last two quarters of 2003. This is a trend which is supported by the Investment Property Databank’s (IPD) UK Digest 2004, which contains annual market analyses of the UK commercial property market from 1981 to 2003. In fact, the UK institutions have decreased their net exposure to property in each of the last three years. In 2003, they were net sellers to the tune of £2.5bn for the first time since IPD’s detailed records of the market began in 1991 (see figure 1).
Net sales of direct property investments may suggest institutions have substantially increased their level of investment in indirect property vehicles, but this is not the case. In 2003, IPD recorded a net investment in indirect property vehicles of £710m, which is well below the five-year average of £1,100m.
Why is this, when, despite recent downward yield adjustments, property retains a considerable yield advantage over other asset classes? The income yield on the IPD monthly index for March was 6.4% and the equivalent annual yield 7.4%, compared to the FT All-Share dividend yield of 3.1% and a yield on the 15-year gilt index of 4.7%. The last five years have seen property offering relatively stable returns with far less of the price volatility experienced in other investment markets (see figure 2).
Property also makes multi-asset portfolios more efficient. The returns on commercial property are weakly correlated to those on other asset classes and, therefore, property assists in the diversification of multi-asset portfolios. Consequently, portfolios with property achieve greater returns for the equivalent level of risk than those portfolios without property.
In the past two years, the All Property IPD Monthly initial yield has fallen from 7.3% to 6.4%, while the equivalent yield has fallen from 8.6% to 7.4% over the same period. This has resulted in capital growth of 2.6% in 2002 and 3.9% in 2003. But, counter-intuitively, this movement in yields has been accompanied by declining rental levels. Rents fell by 0.9% in 2002 and by 1.6% in 2003. For some market commentators this lack of correlation between property yields and rental growth represents worrying signs of a bubble developing.

Risk and return
Market practitioners see the decline in yields as a response to strong investment demand and a limited number of available properties for sale. Investment theory gives a further insight. Investors require compensation for holding a risky asset in the form of additional returns. Property investors require a return over and above that available on the equivalent gilt to compensate them for the additional risk. If an asset’s risk can be measured by the variance of returns then the excess return required is a function of the variance of returns. Falling yields can therefore be seen as a response to declining levels of volatility in the property investment market.
The market is currently divided over the scope for any further decline in yields. Last year, UK institutions took the view they were sellers and not buyers at the prices available, however, overseas and geared investors were heavy buyers of UK property. Overseas investors, private property companies, and private investors made net investments of £3.6bn, £0.6 bn, and £2.5 bn respectively.
This year, however, there may be a change in the attitude of the institutions, attracted to the market by improving fundamentals. As economic growth picks up and generates demand from business for commercial property space, the prospect for rental growth improves. The economy grew strongly in the second half of last year and is expected to grow at trend or better, both this year and next.
Anecdotal evidence suggests that an increase in institutional requirements is already the case. Commercial surveying practices are reporting a sizeable increase in the amount of institutional money available for investment in property this year.

Revised expectations?
The latest Investment Property Forum (IPF) Survey of Independent Forecasts, published in May, indicates the institutions have revised their expectations upwards, but still retain more than a degree of caution. The survey covers 31 property advisors, fund managers, and equity brokers, and the consensus is that total property returns over the period to year-end 2006 will average 9.1% a year with capital growth of 2.2% and rental growth of 1.4%.
Although the latest institutional forecasts suggest that the market will enjoy better returns than the 8.3% expected a quarter earlier, it may well prove that these remain too conservative. Yields on IPD’s Monthly Index fell by 0.2% in Q1 alone and market sentiment suggests that competition between prospective purchasers is continuing to drive prices up and push yields down further.
Over the last property cycle real rental growth has averaged 1% a year. With inflation at 2% a year the expected rental growth rate would be 3%. Taking this expected rental growth rate together with the IPD All Property equivalent yield of 7.25% produces an expected annual rate of return of 10.25%. This suggests that there is ample scope for yields to re-rate further as property fund manager surveys consistently indicate that their target return is in the region of 8%. A 50 basis-point decline in yields in 2004 and a further 25 basis-point decline in 2005 means that property returns between now and the end of 2006 could average 11.2% a year.
This all means that property is highly suited to a long-term diversified portfolio. Moreover, the immediate case for investing in commercial property also remains strong. Institutions should be looking to increase their exposure to commercial property and maintain a constant, high percentage of funds under management in the sector. In addition, the developments currently taking place within the commercial property investment market will allow a wider range of investors to participate, enabling smaller funds and even retail investors to gain access to investment in real estate. This will further strengthen demand for investment-grade property and, will in combination with increasing levels of rental growth, help to keep yields buoyant.

Size matters
There is a perception that direct property portfolios are only for very large funds. In their December Universe, IPD analysed 10,800 properties with a combined value of £105bn and an average lot size of £9.7m. If we combine these numbers with the suggestion that approximately 20 properties are required to produce a reasonably well-diversified property portfolio, then only funds with £190m to spend should aspire to a balanced direct property portfolio. In such circumstances, how are smaller funds and private investors able to participate in direct property investment?
Other routes to gaining a direct exposure to commercial property do exist. For example, by concentrating on segments of the market with smaller average lot sizes, eg standard shops and regional offices, a diversified direct property portfolio becomes viable for smaller funds. In addition, for the last five years or so, tax-paying investors have been able to gain exposure to direct property through one of the growing number of private property vehicles. These vehicles are typically structured as limited partnerships, which permit tax-transparent co-ownership of property portfolios by individuals and corporations.
In the 2004 Budget, the government announced the launch of a consultation process aimed at exploring proposals for a new property investment fund (PIF) in the UK, possibly based on an existing type of property investment fund in the USA. Such vehicles would be designed specifically to promote more flexible investment in property, increase choice for the small investor, and improve liquidity. The consultation process would run until 16 July 2004, so the eventual form of the vehicle will not be known for some time; what is clear, however, is that some powerful forces are at work that should result in more widespread opportunity to invest in commercial property. Recent research conducted by MORI on behalf of the British Property Federation (BPF) reveals that 36% of active investors would be attracted to a product that allowed them to invest directly in commercial property.
In the medium term, exposure to UK commercial property will increase investment returns and reduce risk. Accordingly, investors, both institutional and otherwise, should be considering property as more than an alternative investment class and actively looking to increase their direct property weight.