Ian Whittock forecasts double-digit returns on existing stock for 2010 but longer term he's cautious on the risks of a stalling economy
Following the remarkable turnaround in the performance of the commercial property markets in 2009, I thought it would be worth trying to identify some of the key investment themes and outlook for 2010.
Before making an assessment of the performance potential for the year it is important to differentiate between those already invested and those intending to invest. The reason for this is the large margin between formal valuations on stock currently held and the prices required in order to secure new stock.
Pricing rose so rapidly in the second half of 2009 that it has had the effect of leaving a large gap between market prices and formal valuations. This gap should lessen as we go through the year and evidence of the improving pricing becomes available to valuers. We estimate that at an all-property (market) level the differential is currently of the order of 50 basis points, market prices being higher than indicated by valuations. This is the equivalent of around 10% capital improvement (ignoring falls in rental values). So we would be fairly confident that even after the strong improvement in performance in the last quarter of 2009, we should see a double-digit total return in 2010 on existing stock.
Those investors buying into the market should look forward to an income return of around 6% per annum after costs but more limited capital appreciation. For much of last year one of the biggest challenges for investors was how to dispose of stock. This year the challenge is likely to be the difficulty of acquiring stock.
Any assessment of the outlook would not be complete without identifying the key risks to the market. What we regard as the three key risks are outlined below.
As we argued last year, asset values have risen because of greater confidence on the part of investors now that the risk of further major banks failures has been largely removed, allied to the increase in liquidity and low interest rates provided by central banks. The recovery in values is not about rental growth, which our forecasting models suggest will not arrive at least until the second half of 2011. In the short term, low interest rates are effectively setting a very low discount rate, while in the long term yields (even market yields) remain above fair value. However, in the medium term, say the next two years, there remains significant risk to market values (much less so for valuations) from rising interest rates and a withdrawal of liquidity.
We are not yet operating in a normal free market, economic output and asset valuations are all held up by cheap debt and a high degree of liquidity through quantitative easing (QE).
If we examine first how QE works, we conclude that it has had a marked effect on investment values. The Bank of England buys assets (particularly gilts) from the banks, which increases demand for gilts and forces yields down. This in turn encourages banks to lend on investments offering a more attractive yield. It effectively makes the return on low risk assets penal. The Bank of England helpfully provides a guide as to how QE is to work and this is explicit in its objective, which is to raise asset prices.
The total extent of the QE stimulus is £200m, so the effort has been quite substantial. However, at the moment, there are no plans to extend this beyond March. Furthermore, at some stage the Bank is going to have to dispose of the assets it has accumulated, albeit in a controlled way. A stimulus of this nature has never been tried before and so no one is quite sure what will happen when it is removed. Nevertheless the higher the price of the assets the greater the probability that the withdrawal of QE will hold back values, at least until growth comes along. At the very least it should slow down the rate of capital appreciation.
One thing that can be stated with some certainty is that bond yields and interest rates have to rise. These are subject to a number of upward pressures. These are:
Base rates are forecast to rise to 2% by the end of 2010, still low historically, but it could have a psychological effect on investors as they anticipate further rate rises to come. It also has the effect of raising the discount rate, reducing the attraction of risk assets including property.
The final key risk is the occupational market. This is tied to the strength of economic growth. If the economic recovery stalls on the withdrawal of the fiscal and financial stimulus then this increases the risk of a rise in voids. It would also defer the return of rental growth and accelerate the fall in rental values in the short term.
So while existing investors should look forward to strong returns this year, medium-term risks remain. The next cycle will not begin until we have self sustaining economic growth, ie ex stimulus. While this stimulus is being removed market pricing remains susceptible to a partial temporary setback.
Ian Whittock is chief investment officer, ING Real Estate Investment Management