by Norman Bowie
“Quiet calm cool deliberation untangles every knot” W S Gilbert
The Great Crash of October 19 last year appeared to send hardly a ripple through the property markets. Comments in the subsequent months have given the impression that it is “business as usual” with acquisitions and disposals, whether by sale or by leasing, maintaining values and City office rents breaking new highs.
In the backrooms thoughts and discussions turn on whether, first, there will be a downward reaction in that often the property market moves after the securities markets and, second, what form this will take.
The scene ahead is undoubtedly one of uncertainty. There are as many views on the world economy as there are experts. General agreement points a finger at the USA as unable or unwilling to take any decisive action except to drift. The Japanese, with their enormous trade surplus, are slowly opening their markets to the outside world while the high exchange rate slows down their export volume. This latter trend happens to be of additional value to the UK and other countries.
To the Japanese, UK real estate is cheap — the high yen buys more £s of property and our yields are higher. More Japanese businesses are opening up here in both manufacturing and services. Their construction companies are getting ready to compete openly with the long-established British firms, many of which have an active property development and investment arm. It looks as if Japanese institutions — and even their enormous state pension funds — may be allowed to invest overseas, perhaps in property.
The third arm of the triangle is Germany, where there seems to be a reluctance to cooperate, but this is tempered by the fact that the EEC as a trading unit is now larger than the US. By 1992 the EEC should be a single market, and even more a force to be reckoned with.
The global market is here, and developing. It started with securities and financial services and is now beginning to embrace our home property market. Before the crash the Kiwis, Kangaroos and the Dutch, as well as other overseas interests, were playing the property company share market and treating property as a financial asset. Has the game stopped or merely paused, while share prices are now back to their traditional discount to asset value, having spent a few brief months with their heads high at premium levels?
Some overseas interests, such as the North Americans, can, with careful planning, depreciate buildings for tax purposes against income, a benefit denied to UK citizens. Indeed, some acquisitions of British companies have been so planned that on property realisations the apparent big liability for CGT has vanished into thin air.
The likelihood of VAT being imposed on new construction has rung some alarm bells, but then some people shout before they are hurt: the impact will not be anything like as bad as has been made out. After all, the Irish and most Europeans have lived with it for years. Much of the tax can be passed on to VAT-registered tenants or purchasers; that which may be left with the developer will either come out of his profits or, more likely, depress land values. One thing is certain — it cannot put rents up unless the supply of market space is out of balance with demand.
In times of uncertainty and when the illusion that values always go up and up has been exposed, the person in the street is much more cautious about where his savings go. The unit trusts were booming until the autumn and now their advertisements take up fewer column inches and their claims are more conservative. The non-taxpayer — at long last — is being openly wooed by National Savings, which provide a much more remunerative home for his spare cash than any building society. Curiously the consumer spending boom has continued (although not quite at earlier levels) and credit expands.
Come the spring, employees will have the legal right to step out from and not be forced to join, their employer’s occupational scheme. Everyone will have a right to create his own personal pension plan, and we can expect a big increase in the junk mail pouring through our letter-boxes. These PPPs will largely be promoted by insurance companies, so the important question for the property market is whether this will be a threat and reduce the cash flow from pension funds, who have been heavy investors in property, and a transfer to the insurance companies, many of whom will have a different attitude.
The fall in the stock market by, say, 25% means that overnight the percentage of property in a fund could have risen from 10% to 12.5% if the original allocations had been property 10%: equities 80%: gilts 10%. Some comfort will be drawn from the fact that on performance it may well be that property was almost “Top of the Pops” for 1987. Depending who, by, and how performance is measured, it looks as if total returns ran about 9.5% for equities, just under 10% for cash and perhaps 15% for long-term gilts. It is probable that a well-conceived property portfolio will have earned at least around 20%, and a good high-yield fund should have matched gilts.
The UK economy looks strong for 1988, company profits are rising, unemployment is still falling and the work force increases with consequential demands for additional modern space. Any increasing threat of inflation may increase interest rates. Earnings are above RPI. The $ to £ rate may adversely affect the tourist trade, but US companies and property are cheap for prospective UK predators and investors.
It is often not widely appreciated that the UK property market has a wide range of investors who have different objectives and tax positions. The high individual taxpayer will naturally go for capital growth and low income — long-term reversions having the greatest attraction. The life funds of insurance companies pay tax so that tax allowances are a bonus for them but of no use to pension funds. The shrewd investor and his adviser will always value on a net of tax as well as a gross basis before coming to a final judgment as to the value of a particular investment.
The stock market fall may have been thought to have severely hurt pension funds, but that is not necessarily the case. Their actuarial valuations reflect the assessed future income flows so that increasing dividends or rental income is what is being valued. Capital values can fluctuate with little effect unless a fall means a prospect of a slower growth rate or even reduced dividends or rents. Capital values do have a meaning, however, if the manager intends to convert them to cash for reinvestment in another security giving an enhanced income and prospects for growth. So the pension fund holidays could well continue with an adverse effect on new money available for investment.
Insurance companies are a different animal. The average life of a policy is around 12 to 15 years and policy-holders are tempted not only by the annual bonuses but also the big terminal bonus on maturity which reflects the capital growth of the invested premiums over the policy term. Some of the insurance company leaders have already announced a reduction of their terminal bonuses for December 1987 and January 1988 as compared with that paid out at January 1987.
Equity yields have risen and many sound companies with growth prospects are showing well-covered yields above the bottom end of the property-yield spectrum. This may pose a threat to the prime yields of 4% when the lessee’s equities yield more.
So the investor and his adviser have plenty to think about, quite apart from such factors as the boom in new retail space, new offices springing up in provincial towns, reports of increased demand for industrial space with reduced supply, and the $64,000 question over the likely size of staff redundancies in the City. Is it a time to go for a good running income with a protective yield and sound tenant covenant? Will this beat our equity rivals for the second year running, and prove that property is a good sound haven in times of uncertainty during which volatile stock markets appear influenced more by psychology than sense?