How does commercial property justify its place in a diversified portfolio?
In 2012, direct UK commercial property delivered a total return of 2.7% as a solid income return of 6.0% more than compensated for a modest decline in capital values according to the IPD Quarterly Index*. This performance again demonstrated commercial property’s resilience against the background of a faltering UK economy, and the initial figures for Q1 2013 suggest a further improvement. Commercial property continues to justify its role in a diversified investment portfolio, particularly given the current uncertainty and volatility across other asset classes.
Commercial property is fundamentally an income-driven asset class with the majority of long term performance generated by a high and stable income stream. Between 2001 and 2012 for example, income return accounted for 6.2% pa of the 6.4% pa total return delivered by the asset class.
At Ignis we recognise the importance of income and have structured our investment process to maximise the potential income from our client portfolios. A key objective of active property investment management is to maximise a portfolio’s income stream whilst minimising downside risk. Asset managers should always be disciplined and focussed in the asset management of portfolios, maintaining and wherever possible enhancing, existing income streams.
The UK property market has become increasingly polarised across geography, i.e. London/the South East compared to the wider UK, and quality, i.e. prime versus secondary assets. Although it is anticipated that the divergences between prime versus secondary and London and the rest of the country will continue, there are emerging signs of an increased appetite from certain investors for “good “ secondary properties, particularly where asset management skills can be employed.
So how should investors view the potential returns from real estate in the short to medium term? At Ignis we expect to see a modest improvement in total returns in 2013, although capital values will likely remain under pressure in many markets. The Rest of UK High Street Retail and more peripheral office locations will prove difficult for years to come. The economic climate remains challenging and property ‘fundamentals’ such as lease events and active management will drive investment performance.
The income element of property will drive total returns over the medium term. Ignis Real Estate forecasts a total return of 5.8% for 2013 and 7.2% per annum for the next three years, with the asset class demonstrating less volatility than other asset classes. Employment growth and consumer spending are likely to be weak going forward and this is reflected in modest expectations for average rental growth.
Over the next three years, offices are expected to maintain their position as the top-performing sector, boosted by the performance of the West End and City markets. Polarisation will continue within retail sector subgroups with the limited pipeline expected in retail warehouses and shopping centres continuing to support the stronger locations. Supermarkets let to solid covenants that offer indexation will continue to outperform the wider retail sector.
We are not expecting any great improvement in industrial rents with the sector facing many of the challenges applicable to retail. The picture is slightly better for big sheds and standard industrial units in London as well as local ‘hotspots’ such as Aberdeen and Heathrow.
In a challenging market, we at Ignis believe that purchasing decisions should be determined, first and foremost, by the characteristics of the asset itself rather than sector or macro trends. Therefore, an important part of our current strategy is to identify and acquire new assets that provide an attractive blend of high quality income and asset management prospects.
Income return will continue to be the fundamental building block of commercial property investment returns and the property yield remains a reasonable starting point for reflecting the illiquidity and costs involved when investing in the asset class. It also gives investors a margin over and above anticipated inflation and a nominal ‘risk free’ rate, although this margin should not be seen as route to outperformance through yield compression. The requirement for liquidity and risk to income will ensure, assuming that investors act rationally, a higher risk premium for property is a long term consequence of the boom/bust cycle over the last decade, and offers investors some protection if the economic recovery disappoints.