Investors should consider overweighting real estate even under the assumption of different macroeconomic scenarios, says Michael Haddock
Prices and investment activity in the commercial real estate sector held up remarkably well in 2011, in the context of the euro-zone sovereign debt crisis and sharp downgrades in economic growth forecasts.
One might normally expect an illiquid asset such as property to perform relatively poorly under such circumstances, yet investors continue to increase allocations to real estate.
The uncertain financial environment is amplifying investors' attitude to risk. For them, the possibility of a 50% fall in capital value has more influence on the investment decision than the chance of a 50% increase. This is particularly relevant for an asset such as real estate.
For many properties, a relatively high proportion of the value is in its physical characteristics (land and buildings) rather than its financial characteristics (the lease). This provides the investor with the reassurance that, even in the most extreme circumstances, a total loss is unlikely.
The Lehman collapse provides a clear example of this. It is unlikely that either bondholders or shareholders will get a substantial return from the winding-up process. Contrast this with the position of the former owners of Lehman's UK headquarters. The administrator continued to pay most of the rent while the European operations were being transferred to Nomura, with sub-tenants in the providing additional security of income. Subsequently, the building was sold to JP Morgan for £495m.
The investor in real estate debt is the greatest beneficiary from this effect, and the lower the loan to value (LTV) level, the greater the security. In fact for certain groups of investors there is currently a strong case for investment in new real estate debt. At relatively low LTVs this offers a high level of security. However, because a legacy of bad loans is preventing many traditional lenders from originating new loans, the interest rate on new real estate lending is high relative to other fixed-rate investments.
Real estate combines features of bonds and equities. The ability to provide certainty of income and the possibility of potential uplifts in rent paid (and thus in capital value) is particularly valuable. The extent to which real estate is a good hedge against inflation is hotly debated. However, there is at least the possibility that income will rise, making it a better inflation hedge than a pure bond investment.
Individual properties differ in the extent to which they achieve this bond-equity trade-off. The creditworthiness of the current occupier will vary even between identical properties. While real estate as an asset class is often described as having the equivalent of a BBB credit rating, individual properties can represent every point on the scale. This gives the investor the opportunity to select the level of trade-off they wish to achieve.
The most bond-like properties are highly prized by investors at the moment. However, capital has also flowed towards secure government and corporate bonds. Despite the recent fall in prime property yields, the yield gap has increased and is arguably at a long-term high.
The distribution of returns between income and capital value is also an important part of the investment decision, particularly for investors who follow an asset-liability matching strategy.
Such strategies are becoming ever more appropriate as developed-country pension funds move from net cash inflows to net cash outflows. As they do so, current yield becomes more important than long-term capital value growth.
Compared with other asset classes, the initial yield generated by real estate is high. The average income return from UK property is well over 6.5% (source: IPD monthly index), compared with a yield of 3.4% on the FTSE 100. The income yield on government bonds varies depending on the coupon, but with redemption yields well below 2.5% for German and UK bonds, higher incomes come at the cost of a substantial loss in capital value at maturity.
It could be argued this is not comparing like with like in terms of asset quality, but even the most prime properties will normally offer an income advantage over gilts or equities, with the West End office yield currently around 4%.
Rental income is also very stable. From its peak in September 2008 to January 2012, the aggregate rental income generated by the portfolio that makes up the UK IPD monthly index fell by just 2.2%. Increased voids have been almost completely offset by rent reviews that captured historical rental growth as a result of the UK's five-yearly rent review pattern.
If property as an asset class is underpriced there is a case for investment because of the expectation that it will generate higher risk-adjusted returns in the short to medium term.
The simplest way to consider the relative price of real estate compared with other asset classes is the yield gap relative to bonds.
The weakening economic outlook, reducing expected income growth, means we would expect the yield gap to be increasing. But the extent of this over the past four years is remarkable. In much of Europe, real estate investors need to achieve little or no income growth in the medium term to justify current prices for prime property relative to bonds.
In western European cities, the annual level of new office completions is running at historically low levels. Moreover, the availability of finance has yet to recover and development starts remain very low.
The small number of projects set to complete over the next few years will help to protect occupancy rates and rental values in the event that occupier demand is subdued. If, on the other hand, occupier demand exceeds the expected level it is likely to result in a marked shortage of good-quality space and potentially quite strong rental value growth.
The most persuasive argument in favour of real estate is that it offers a positive investment case not just against the most likely economic outlook, but also against other scenarios:
• The euro-zone crisis continues with no clear resolution: prime property generates a higher income return than bonds, with the lack of new development completions helping to maintain occupancy rates and continued income generation;
• Dealing with the sovereign debt crisis results in inflation: Continental markets benefit from indexation in the short term. In the longer term, real estate is a better hedge against inflation than fixed income bonds;
• Resolution of the sovereign debt crisis results in economic recovery: occupier demand improves, occupancy rates increase. Longer term, lack of new development completions results in a shortage of good-quality space and rental growth, increasing income and capital values.
While other asset classes might produce better returns under specific outcomes, real estate performs in multiple scenarios, making a strong case for investors to overweight property in their portfolios.
Michael Haddock is a senior director at CBRE