While the UK market approaches fair value, uncertainty persists and there are bargains to be had for the savvy investor. Sarah Bate reports
Strong performance of UK commercial property when capital growth and strong investor demand drove performance up and yields down continued into the first half of 2007 before coming to an abrupt halt during the summer when the global credit crunch caused the UK commercial property markets to anticipate pricing adjustments. In September rising yields and lower capital values delivered a monthly total return of -1.2%, the first negative IPD figure in 15 years and a trend that looks set to continue into 2008.
After 15 years' unbroken positive returns investors are rattled and, as a consequence, a dramatic upward yield drift has resulted in very limited market activity. Although global tightening of credit acted as a catalyst, the inflection point
in the UK occurred principally as a result of the steadily increasing cost of debt. Low interest rates made self-financing property investment highly compelling until borrowing costs began to deter the debt-driven investor. The market had overheated.
There is intense discussion about the extent to which UK property prices have further to fall. Although there is currently little evidence of distressed sellers in the market many investors are sitting on their hands waiting for someone else to transact while others try to decide if the recent sharp correction is the beginning (or the end) of a further erosion of values.
It may therefore be somewhat timely to be asking if UK commercial property offers fair value at today's pricing levels. As an asset class, property is generally recognised to be a hybrid: sharing some of the performance characteristics of both bonds and equities, by enjoying a bond income with an equity kicker.
Historical data indicate that property volatility has been appreciably less than that for equities or bonds and that the correlation between property performance and that of the other two asset classes is by far the weakest of the relationships. Property, therefore, is seen as offering portfolio risk reduction and as a good diversifier within an investment portfolio including equities and gilts.
These characteristics form part of an investor's considerations when assessing the fair value for property. ‘Fair value' is not an analysis of whether today's price is cheaper than yesterday's or even whether it may be cheaper tomorrow - it is all about whether or not an asset offers value in line with the role of property as an asset class.
A disciplined approach to fair value pricing can be represented by the following equation:
RFR + PRP = K + RG - Dep
RFR = risk-free rate
PRP = property risk premium
RG = rental growth
Dep = depreciation
The risk-free rate is a UK government bond. The property risk premium, the yield premium required to induce investors to hold property over bonds, based upon relative historical performance, is generally accepted to be in the region of 2.5% over the long term. This premium is time-varying in accordance with market cycles and, as yields have come in over the last few years, so risk premiums have reduced.
The other inputs, rental growth and depreciation, can be slightly more subjective. While it is considered acceptable to apply a standard depreciation rate of 2% for commercial (office, retail, industrial/warehouse) property, each sector depreciates at differing rates and can be analysed separately.
More subjective is an assumed rental growth projection which is heavily reliant upon the relative strength of the occupational markets, which respond closely to economic conditions at both the macro and micro level.
The tenant market across the UK is currently faring rather well. Indeed, each property segment has enjoyed rental growth over the course of the last few years and, although slowing in some areas, the outlook remains positive.
Keep in mind that direct comparison of the most recent IPD equivalent yield results and the results of our fair value equivalent yield analysis does not necessarily indicate whether the UK property market as an asset class has fully or sufficiently repriced itself appropriately yet. IPD results, being reliant on the valuation process, tend to lag the arrival of transaction evidence before pricing in a changing market direction. This leads to a smoothing in market performance figures.
Although valuers are taking sentiment into account and marking capital values down faster than they have in the past, the correction is taking place quickly and we think today's transaction levels reflect a notable discount even on October's valuations.
Taking all of the above into account, we have modelled our assessment of fair value against today's property pricing. The over-riding conclusion is that following recent market adjustments average UK commercial property market may already be offering close to fair value in relation to the other asset classes, presupposing of course that bond and equity prices remain relatively stable. Many would-be purchasers are bidding today at their view of tomorrow's price.
There are, of course some property segments that fare better than others, with retail warehouses and industrial estates actually appearing to be relatively undervalued at present. In contrast the office sector in general still needs to see yields rise by approximately 10% to achieve fair value.
This latter point is particularly poignant within the London City market where yields have moved out by around 100bps and yet the risks with regard to rental prospects are on the downside in the light of financial market uncertainty.
So the recent upward yield drift has brought the perceived value of UK property more closely into line with market pricing, although the current absence of substantial market activity makes judgement less than usually empirical. In periods of uncertainty such as this the savvy investor, cashed-up and ready to go, will unquestionably benefit from exploiting any weakness in what has hitherto been a sellers' market.
It is no coincidence already to see the arrival of potentially significant sources of new real estate equity (fully supported by guaranteed debt) ready to snap up, vulture-like, suitable assets from any source that hints of distress. There could be some interesting buying opportunities, and money to be made, over the coming six to nine months.
Sarah Bate is director of research at Rockspring PIM