Commercial property - have you missed the boat?

The commercial property sector started to tank some way ahead of the stock market – the cracks were already showing in 2007. Values fell by 35-40%, and property stocks fell even faster, with many REITs 80% down on their peak values [ref] Investors Chronicle, 23 March 2009, http://www.investorschronicle.co.uk/MarketsAndSectors/Sectors/article/20090323/d9edc8a8-1572-11de-a6cb-00144f2af8e8/LOWDOWN--COMMERCIAL-PROPERTY-REITS.jsp [/ref] .

Values had risen fast in the years up to 2007 as speculative money entered the market. At the same time, developers were pushing new properties up as fast as they could, so that a huge amount of new space became available just as the economy began to slide.

Many REITs were left with high levels of debt, and rental income no longer growing. A series of rescue rights issues followed, in early 2009. Perhaps that was the start of the rebound; few of the companies involved had much difficulty raising funds from the City.

Since the low point earlier this year, most property stocks have rebounded, some by more than 50%. So, is is too late to get back into property – have investors who still have no weighting in the sector missed the boat?

Perhaps not. The benchmark IPD index for UK property shows it yielding 8% - more than double the yield on gilts, and several times more than even the best savings accounts [ref] Telegraph, 3 September 2009 http://www.telegraph.co.uk/finance/personalfinance/investing/6130046/Is-commercial-property-on-the-up.html  [/ref] . (There's a good table showing spreads between property and gilt yields in the Hammerson Plc half year results [ref] http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MzQ2MjgwfENoaWxkSUQ9MzM0MzU0fFR5cGU9MQ==&t=1"  [/ref] .) Some property companies are aiming to purchase properties at considerably larger yields – Hansteen Hldgs UK Industrial Property Unit Trust is aiming to get 12 to 15% annual returns [ref] Hansteen press release, 3 August 2009, http://www.hansteen.co.uk/media/press_release.php?rel_ID=33  [/ref] and it seems unlikely the company is betting on much return from price appreciation in the short term.

The series of rescue rights issues earlier this year removed much of the corporate risk from the sector. And occupancy levels, except in retail, appear to have held up reasonably well. Much of the collapse in value was driven by yields increasing dramatically, while declines in rentals have generally been minimal. At Workspace Group Plc, for instance, the rent roll fell only 3.5% for the year to June 2009 [ref] Workspace preliminary results presentation http://www.workspacegroup.co.uk/repository/documents/corporate/March%202009%20Results%20FINAL.pdf  [/ref] .

Rental values are still falling, however. That appears to be well discounted; some observers believe the market is already pricing in a further 20% fall in primary office rents. This will impact companies with a high amount of development coming on stream in the next year or so, and companies with low occupancy rates, or with a large proportion of tenants able to break their leases, or coming up for renewal. However, those REITs which have mature portfolios, well let, and with longer term leases, are less likely to see shortfalls in their rental income. Detailed research is vital here!

 The main risk for the better quality companies is that further deterioriation of the economy could lead to bankruptcies – decimating existing tenants. That doesn't seem to be happening at the moment, though.

 So does the sector look attractive? Institutional investors appear to be saying 'yes'. They are now moving back into the market, with funds such as Aberdeen and Henderson now actively looking to buy properties [ref] Citywire article, 7 September 2009, http://www.citywire.co.uk/adviser/-/features/market-tactics/content.aspx?ID=356283&Page=2 [/ref] .

 Few individual investors have the wherewithal to buy a commercial property of their own. So the choice comes down to whether to invest in a quoted property company, an investment trust or OEIC, or an ETF – or perhaps a mixture of these instruments.

 An increasing proportion of quoted property companies have now become REITs, a status which offers significant tax advantages. To qualify, a REIT has to distribute 90% of its rental income in dividends – guaranteeing high levels of income for investors.

 The historic yield on the sector is 7.4%, though that might be misleading since many of the larger companies will be cutting dividends this year. However, unlike some other sectors (pubs for example) this is a sector where dividends will continue to be paid, even if at a lower level. After all, one of the great attractions of property investment companies is that their rental income streams are both strong and predictable.

 Most REITs are now trading at a premium to book value. For instance Primary Health Properties, which owns health sector properties, trades at a 40% premium to net assets – but pays a 5.3% yield. Investors have to take a chance that the net assets will revalue upwards over the next couple of years. Land Securities Group Plc is expected to pay around 4% yield this year – half its last dividend – but trades at only a 10% premium.

 Another way into the sector is to consider collective investment funds. OEICs showed in 2007 that they are not best suited to investing in property, which is an illiquid investment; many of them prevented investors from selling their units, fearing that high levels of investor redemptions would force them to sell property into a falling market. Investors might therefore want to choose a closed-end fund.

 Investment trusts that invest in physical real estate – rather than investing in property company shares – include Tr Property and F & C Commercial Property . Tr Property is a well regarded trust, trading roughly at parity with its asset value and offering a yield of 3.3%. F & C Commercial Property trades at a higher premium to its asset value, but offers a higher yield, at 6.9%. But perhaps the most interesting simply on the stats is Axa Property Trust, which invests across Europe, with particularly strong positions in Germany and the Netherlands. It's trading at a 37% discount to net assets, and offers a 7.4% yield – very respectable.

 But perhaps the simplest way to go for property is with an ETF. Invest directly in the IPD Index, rather than trusting a REIT or investment fund manager. Some, though, merely duplicate the stock market – £IUKP has over half its assets in four big REITs. Ishares Ftse Euro Prop on the other hand excludes the UK, concentrating on European property – so it can bring diversification to your comemrcial property portfolio. Investors in ETFs also benefit from not having to pay stamp duty – an advantage over direct investment in shares. (And yes, you do get the dividend income with the ETF.)

 While the standout value seen in the sector earlier this year might no longer be there, commercial property still appears to offer above average yields and the prospect of capital growth in 2011-12. But as much as in any other sector, investors need to do their own research on the quality and diversity of each company's assets, before parting with their money.