UK Commercial Property - What Lies Ahead?
Author:
Paul Leonard
Irish investors have been very active in the UK property market in recent years and it is estimated that they have invested over £2 billion during 2004. This paper examines the current position of the UK commercial property market and the factors which may impact upon it in the period ahead.
The UK property market has traditionally been highly cyclical with periods of rapid value growth followed by collapse. The collapse usually demonstrates to the market that it has taken undue risk for which it has not received adequate reward.
Typically, the elements of the cycle start in Central London and radiate out to other parts of the UK, frequently running out of steam before they reach the North and Scotland, leaving these areas with a much less volatile market. Hence the Central London office market is usually the first to subside and the first to show signs of recovery. It would follow then that usually a collapse in rental values in offices in the City of London would be followed by a general slump in the property market. Yet although office rental values in the City have fallen over the last 4 years by over 50% with vacancy rates of up to 15%, the property market has enjoyed a period of strong investment with values increasing at a much higher rate than gilts or equities. Perhaps this time the mould has been broken and the market is better able to ignore bad news.
The market was dominated up to the 1980s by the financial institutions - the pension funds and insurance companies - which invested in commercial property as part of their overall portfolios. Over a number of years the institutions have been reducing the proportion of their funds invested in property and have been encouraged to do this, inter alia, because of the perceived relative illiquidity of property. Government stock, bonds and equities can be sold immediately on the Stock Market but sale of commercial property can take months.
The result of the 1980s reduction in institutional allocation to holdings of property was an explosion in the size of the debt funded sector, with bank debt to property rising from around £6 billion in 1986 to £41 billion at the market peak just 3 years later. Although the early 1990s, following the property market collapse, saw an initial reduction in the quantum of bank lending to the sector, property debt has risen for the last 10 years at rates of up to 25% per annum to a figure which is now estimated to be at over £130 billion. The banking sector has therefore injected an average of almost £10 billion per annum into the UK commercial property market for each of the last 10 years.
Today not only are there over 50 banks in the UK keen to increase the size of their property loan portfolios, but in the past 12 months the institutions, disenchanted with equities, have joined the buyers for property with a vengeance. The result has been that investment yields have fallen to levels not seen for 20 years and in consequence values have risen. This has naturally raised questions as to whether the market is overheated and where will it go next. The bears, including the UK property companies which have been heavy net sellers of property in 2004, argue that the steam will run out of the market shortly while the bulls contend that the market is now in recovery mode.
One of the things which has been peculiar to the recent boom in values has been a so called yield compression. This means that whereas traditionally there has been a gap of a few percentage points between the yield at which the best quality property sold and that at which secondary quality property sold, today that gap has shrunk to only about one percentage point. Suddenly many people in the market are asking why there is any reason for buying secondary property when they can pay only a slightly higher price and buy the best. A correction in the values of secondary property therefore looks likely.
Fundamentals suggest that current yields cannot be justified. It might therefore be a time to worry that the fall in yields could reverse. However either side of 1980 investment yields were lower than now and bulls argue today that we could readily see a return to those lower yield levels, particularly given the current sustained low inflation and interest rate environment.
The market bulls see massive volumes of money, both equity and debt, still waiting to be invested in the market. Perhaps a much greater amount of investment could be attracted if property were to become more liquid. The market has for many years tried to encourage successive Governments to permit the existence of tax transparent securitised vehicles which would enable the retail investor to come into a market which currently is only accessible to larger investors because property tends to come in large lot sizes. The introduction of Real Estate Investment Trusts is something which the current Government has indicated might be authorised, but a hoped-for start in 2005 was deferred in the recent Queen's Speech. No indication has been given by the Government as to the likely detail of the structure of REITs. Bears will argue that the Government primarily sees REITs as a way of attracting new investment in social housing and that REITs will not extend to the commercial market. Bears might also argue that the market is so awash with cash now that REITs cannot improve things further.
Property has generally been viewed as an illiquid equity play but in the early 1990s the long secure rental streams coming from long leases encouraged investors into the property market on the basis that properties were akin to bonds. Under the legal concept known as Privity of Contract tenants of English commercial buildings had a liability to effectively guarantee the payment of rent and outgoings due under a lease for the full lease term even if they had assigned the lease to another tenant. Tenants, such as multiple retailers, who signed 25 year leases but moved premises frequently, built up a huge potential liability. Such tenants faced having to show these long term contingent liabilities in their accounts. They lobbied the Government, which removed Privity from leases granted after 1st January 1996. The effect was to reduce the security of income streams available to investors. Although at the time the investment market saw this as wholly unfair to investors, the market has adapted readily to allow for this change.
Following their success in removing Privity, tenants again sought to reduce the security of income to investors by asking the Government to remove the concept of the upward only rent review. Today a rent review in a poor letting market will mean that the rent remains at its previous level rather than reducing to the lower rental level being seen in then current lettings. In and after a poor letting market many tenants will find themselves paying a rent much higher than properties are currently achieving on new lettings. The erosion of the upward only rent review would remove this anomaly. Although removal of the upward only clause would greatly help tenants, perception is that it could massively hurt investors. However research today suggests that 75% of commercial property is being let on leases with less than 5 years unexpired; accordingly most properties will not be subject to rent reviews and upon expiry new leases granted will probably be for only 5 years, with no rent review. If this is the case, then the abolition of upward only rent reviews may have little impact on the market although investors and their lenders would like to see an unlikely return to longer leases.
If there are occupational concerns in the market today they will probably be centred around the prospects for rental growth. Central London office rental values, having been massively depressed for 4 years were expected to recover during 2004. This recovery has been much less than expected, suggesting that the demand for space from tenants has not returned as early and as strongly as it might have. Outside London, office rents are stable. Shop rental values might seem a sector which could be running out of steam yet retail sales continue to grow, giving support to current rental levels.
In the short term prospects for the UK property market are reasonable with continued strong demand for investments from both institutions and debt driven buyers possibly driving yields even further down. Future rental growth will confirm whether or not these yields are justifiable. The consensus view is that secondary property yields are expected to edge upwards.
It is tempting to say that this time things are different - that the traditional boom and bust may have come to an end - and this may actually be true. Investors buying UK property over the past few years have done very well with good capital growth and property has been seen by many as a "one way bet". The consensus view among banks and property advisers is that UK property remains an attractive asset but that greater caution and perhaps market insight will be needed on the part of investors going forward.