Income returns likely to drive UK commercial property over the near term

As the economy continues on its slow recovery the demand for commercial property as an  asset class will increase, driven by the strength of income returns with pockets of value both in prime and secondary markets, it is claimed.

‘After a turbulent period, commercial property is now seeing steady performance, with total returns year to date driven largely by income, according to Julian Smith, Fund Director of the F&C UK Property Fund, which was launched in June 2010.

He pointed out that capital values are 17% above the market trough of 2009 but still more than 34% below the market peak, providing an attractive entry point for new investors.

'Property total returns have exceeded those of both equities and gilts over the past 10 years to June 2011. Property returns were 2.1%, 4.4% and 9.1% over the second quarter, the first half and the last 12 months respectively; the bulk of the performance came courtesy of income returns and we anticipate this trend will continue for the foreseeable future,' he added.

The geographic bias in performance, with London outperforming the provinces, has gathered pace this year, a trend which Smith and Guy Glover, Fund Manager on the Fund, believe is set to continue for some time as austerity measures tighten their grip throughout the UK.

‘We remain positive on the commercial property market in London, however we anticipate the pace of rental growth here will slow somewhat from here. Throughout the UK, pockets of value can still be found where in our view prices on a relative basis could be considered more attractive, particularly when the most advantageous conditions converge identifying the right property in the right location, at the right price with the right tenant will be key for investors, explained Glover.

They also pointed out that the gap between prime and secondary property has expanded since the onset of the credit crunch and could potentially widen further. Prime is considered to offer greater stability in terms of high-quality buildings and tenants with long leases, but yields will often struggle to exceed 4 to 6%. But while secondary property may include lower quality buildings and less attractive tenants with shorter leases, it typically offers income of around 7 to 12%.
 
Consequently, Smith and Glover believe there is a place for both prime and secondary properties in a diversified property portfolio, particularly good-quality secondary property where investors can take advantage of mispricing in the market to gain access to an attractive income. At the riskier end of the spectrum, Smith and Glover caution that a combination of diligent research and flexibility should be the key to unlocking the best opportunities.

Commercial property has long being considered a hedge against inflation. However, the relationship between the two depends largely on the economic and market backdrop.

From 1971 to 2010, inflation was above average in fourteen years. In those years, among the three asset classes, equities held the top position five times, property five times and gilts four times in terms of total return. Property delivered top performance only in the inflationary period of the 1970s to the 1980s,’ said Smith.

‘There may be some upside when inflation rises, but this depends entirely on the economic environment. We are currently experiencing cost push inflation where prices are rising at the input level but firms cannot pass the increase on fully due to lack of demand. Against this backdrop, it is unlikely that inflation will feed through to rents,’ he added.

The pair conclude that commercial property remains attractive against an uncertain backdrop.
With the economic outlook uncertain and government austerity measures beginning to bite, the coming year is expected to see property deliver total returns broadly in line with income. In the medium term, as the economic recovery progresses and rental growth broadens, property is expected to deliver total returns averaging around 8% a year over the five years to 2015. Furthermore, the income return from property has been steady at around 6% pa for the last decade, very attractive in comparison with other asset classes at a time when interest rates are at record low levels.

‘The outlook remains challenging; however, property is forecast to deliver positive total returns and provide investors with an attractive level of income. Within the F&C UK Property Fund, our focus is on those properties, across the entire spectrum, that offer both strong long term value and opportunities for capital growth whilst maintaining a healthy income stream,’ said Smith.