British commercial property values have been flat — just like the British economy — for the past two years. It’s been a battle between high yields, which are juicier by far than those from equities and bonds, and falling rents.
Tenants under the cosh downsize, leave property when leases end, wriggle out using the prepack trick, or just go bust. If your tenants are reliable rent payers for the long term, property’s a steal. But if they are shaky or on short leases, empty rates can make it a nightmare.
The leading property valuers are getting so much of the market wrong: they are there or thereabouts on yields, but well behind the game on rents.
he rental value of a property is what you can relet it for today if you lose your tenant. It’s that simple. Trust me, tenants know that now, so every lease renewal turns into a new letting, and tenants want a bung or a rent cut or both — even when they are trading well and are going to stay.
I have been managing big institutional property portfolios now for 30 years and something really significant has happened in the last two. British property has been and always will be cyclical, and usually almost all property values go in the same direction. In a falling market, some types of property — those with better tenants and locations, and longer leases — are more defensive, and they tend to decline more slowly in value, but they still go down.
In raging bull markets, such as 2005 to 2007, the high-risk stuff with short leases or speculative angles leads the way. Again, a rising tide floats most boats.
But this time it’s different. Our portfolios have shown little overall change in capital value over the past two years, yet plenty of properties have been going up consistently, while plenty more have been falling quarter by quarter.
Property let at affordable rents to strong covenants on long leases, preferably with inflation-linked or fixed-rent reviews, is getting steadily scarcer and more valuable, even with no economic — and therefore open market rental value — growth. But with average unexpired lease lengths on properties in the IPD index now down to six years, against 12 in the last property crash 20 years ago, and overrenting now outweighing reversions, most UK commercial property is falling in value and has only one way to go.
Property rents, like unemployment, lag the real economy and, like unemployment, they need some real economic growth — about 1% to 1.5% a year — to stay level in real terms. Empty rates make it too painful to lose a tenant, or not replace them as soon as possible if they leave, so landlords are now biting the bullet and letting property at genuine market rents — not clinging to a historic headline figure, which they can only hold by stuffing tenants’ mouths with gold.
So falling rental values for most types of commercial property in most parts of Britain are baked in the cake for at least the next two years, and maybe more, unless the economy accelerates back to its traditional 2%-3% post-recession real growth rates soon. And with the banks still
not lending to small business and the credit squeeze getting worse, don’t hold your breath!
But there is some good news on the way for property. Inflation rising at 5% a year against pay growing at 2% — if you were lucky — savaged household budgets and crippled consumer spending. But now it’s tumbling fast and should be back down to the Bank of England’s official 2% target later this year. That stops the squeeze on real incomes and shines the spotlight on the excellent value offered by safe property.
Now you don’t need any rental growth at all to deliver a decent real yield from property bought to show 6% or 7% initial return. When pension funds are desperate to derisk and match their long-term inflation-linked liabilities, but choke on index-linked gilts at negative real yields, indexed property offers outstanding value as an alternative way to access long-term inflation-linked returns.
If an index-linked property ticks all the boxes of the big insurance companies’ annuity funds — 15 years’ minimum income, blue chip covenant, large lot size, virtually non-assignable lease, then they bid the yield down aggressively.
But if it doesn’t quite ring their bell, we’re here to help. If the tenant, lease and price are right — whatever and wherever the property in the UK — we’ll buy it!
If you think happy days will be here again soon in our economy, there’s some exciting “opportunity property” out there for you to buy at double-figure yields, as the banks now really want to get shot.
But if, like me, you believe the road to recovery will be long, hard and slow, and have more dips and bumps along the way, then play it safe, stick to solid tenants and realistic rents. You might well make money, even when the valuers face facts at last and most property prices fall.
Lord Oakeshott is chairman of OLIM Property, the fund manager he founded in 1986, sold in 2000, and bought back this week