Like peeling back the skin of an onion, each layer of the property investment market reveals something different about the state of play and, unless you have prepared properly, you may well end up in tears.
Property has traditionally assessed yields relative to the anticipation of rental growth. Today’s eye-wateringly low yields are not consistent with normal assumptions. Rents in many sectors have recently reached all-time highs, but in the last year or so they have started to soften. The exception is the tortured retail sector, where rents have generally collapsed and there are no signs we have reached the bottom.
In the office market, certain subsectors have been significantly distorted by tech and serviced office occupiers accounting for unprecedentedly rapid growth in occupational take-up over the last few years. Prima facie, this demand has sustained and grown rental levels but it has also contributed to the masking of the secondhand market, where net absorption numbers are hard to come by.
Today, a Sword of Damocles is hanging over every office building and shopping centre landlord’s balance sheet liabilities and cashflow. Short-term, all-inclusive leases are here to stay, and this has created a massive transitioning of cost burden from the tenant paying service charges to the landlord, who now must shoulder the materially increasing costs and risks of obsolescence, which will only increase as inclusive rents become the norm.
The issue with the new generation of flexible office space providers is that market rents are certainly not being charged by the more aggressive operators in an offensive for market share grab.
Just how much that is distorting an already febrile market is difficult to say. Serviced operators can afford to charge nothing while they are enjoying a rent-free period, but we’ve all seen how that story can play out once the full rental liabilities come on stream.
Equally, the ever-growing tech sector has for years relied heavily on easy money for non-revenue-producing funding. This cash seems to be hitting the skids a bit as well, with only the best-in-breed businesses able to readily raise funds. What will happen to the phalanx of low- or no-revenue, cash-burning tech businesses going forwards? I don’t know but I’m pretty sure it’s not good for real estate.
Choppy waters ahead
I am writing this without the knowledge of whether we are leaving, staying or delaying Brexit. I’m not sure how much it matters in the medium term. With talk of open-ended property funds suffering redemptions and the stresses I just mentioned, it feels like there are choppy waters ahead. I am concerned that we have had a bull market since 2009 and outside retail we have yet to have a correction of any sort despite the significant headwinds.
“What will happen to the phalanx of low- or no-revenue tech businesses going forwards?”
Historically, retail used to make up some 50% of institutional investors’ portfolios. It’s probably fair to say the weighting they want now is close to zero. Those who have transitioned have gone to sheds, the ‘new retail’, and in doing so driven yields to levels I haven’t seen in 35 years in property. In defence of sheds, they have one characteristic that investors find extremely attractive – very low obsolescence. A bit of brick and crinkly tin is within most property owners’ capabilities… or should be. However, the capital values per square foot are sometimes alarming.
This month’s wall of worry is focused on the office market supply and demand. Requirements are changing rapidly. The way we occupy space and how much of it we need, combined with technological innovation, will result in plateauing and, very possibly, a downward trend in rents for several years to come.
If my contention is vaguely correct and, of course ignoring retail, I am curious as to why, even with low interest rates, yields for short-dated income in particular have not been softening?
My belief is they will.
Pass the knife, I’m going back to my onion.
Nick Leslau is chairman of Prestbury Investments
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