by Daniel Ward
There is no doubt that the traditional property investment market has gone into a state of hibernation since the late summer of 1989. The danger of this deep sleep is that the growing number of willing sellers outstrips the somnulent buyers and so, as any basic textbook will tell you, prices come down. It is all very simple — but where does it leave us?
From an agent’s point of view we can admire the scenery and hope to catch a paddle lost by another canoeist. But, more interestingly, what should the fund manager be thinking? All our fortunes are linked.
The typical fund will have a predictable split of offices, retail and industrial, of which there may be one or two “trophy” buildings (they look good in the brochure and everyone enjoys the odd big deal). The rest will be the traditional favourites, with a likely bias for prime or good secondary offices and shops in larger towns. The industrials are likely to be South-Eastern, with the mandatory bolt-on out-of-town retail park and perhaps, if you are “lucky”, a B1 (ex-hi-tech) business space investment — remember those?
None of these now sound very exciting, especially the retail elements, with continued concern for rental growth — and let us face it, if you bought on circa 4% yields the last thing you want is doubt about rental growth. There is also concern about the effects of the UBR and, in my view, no one really knows what the future trend in retailing in Great Britain is likely to be. There have been plenty of new out-of-town schemes built, plenty proposed and seemingly plenty now on the back burner. The insatiable appetite of the British to borrow more and more to buy goodness knows what from goodness knows where still seems to grow. None the less, retailer demand and rental bids, the source of growth, have declined. So the retail portfolio is being revalued, at probably 0.75% on prime and up to 2% on secondary yields over the past 12 months, giving sizeable reductions in capital value.
The office portfolio may be a rosier short- to medium-term prospect. Again, there has been a strong recent history of rental growth, which actually never prompted any great reduction in yields outside London, so there is less valuation risk of downward movement. But the likely future rental growth is limited with a large amount of new supply still being constructed in all the bigger centres and, possibly, three- to five-year voids on new construction. Stagnation of rents is not unheard of post-1973, where the circumstances have been, in some respects, similar.
The industrial sector has been the recent darling of most fund managers, having been locked in a cupboard marked “sector allocation” for many years. The tremendous growth explosion was a surprise to most people who were unaware of the potential demand which suddenly manifested itself, with huge increases in site values and building costs. Tenants actually competed for new space! But again, it is hard to see this enthusiasm being sustained, and very quickly yields are being marked out, in many cases to double figures.
The B1/hi-tech/business space, call it what you will, has been the largest moving target of the past decade. I do not think that anyone knows how to provide flexible space. Requirements alter so frequently, and the same applies to out-of-town retail. At one time everyone wanted it and yields went down and down, then tenant demand shifted from second- to third- and now fourth-generation retail parks, and who knows if it has yet settled. This lends doubt to the valuation future of the outdated space with dire effects on the optimistic yields paid, in many cases, less than five years ago.
So this presents a rather gloomy outlook for most traditional portfolios. What can be done? One answer is to do nothing and hope for the best — that way one’s performance is likely to be no worse than anyone else’s. A not unattractive option is to enjoy high cash returns on stockpiled income. But if you wish to retain a strong property presence and benefit from greater returns in uncertain times then I would recommend an additional portfolio of well-selected secondary property.
This category is broadly described as property in the 8% to 12% institutional vacuum traditionally filled by property companies and individuals. It is consistently ignored by institutions (because it is “risky”), multiple tenants, older buildings, secondary locations and management problems. The truth is that it is often the funds themselves which have created these underperformers by buying them new in the first place. But rather than re-address an underperformer as a secondary property at a realistic value, what happens? It gets sold as a bad experience. The new owner is the lucky one: someone else has taken the drop, and in doing so given him a nice high yield initially, with only a small amount of rental growth needed to give above-average returns. Frequently there are also secondary “lucky breaks” owing to high relative site values. By this I mean, for instance, inner-city space being re-classified as retail or B1, or simply on refurbishment.
To give more specific examples of the “ugly duckling” portfolio, these are the properties which suffer from the misconception of risk. High initial returns in property are not necessarily determinants of a lack of long-term growth or tenant instability. They often simply do not look or sound very glamorous. And really, to put it in a nutshell, they are more difficult to manage. It is often this alone, rather than anything else, which has served to set them apart. Because there have been long-term small problems — say an awkward tenant, nagging constructional defects, awkward lease terms or difficult rent reviews — the property gets a bad name. The easiest way to solve this is to put it on the sell list and let someone else worry about it. It is usually easier to replace a troublesome property rather than a troublesome manager, but nevertheless the cart is still before the horse.
To assist in the selection procedure, the basics apply — look for value for money. It is not a crime to buy something that looks cheap on a capital value per square foot basis. This applies to retail as much as to offices and sheds. Look for a nice big site, again value for money. Do not worry too much about cosmetics. Most buildings have more structural integrity than they are given credit for. It is worth bearing in mind that the economic lives of these structures are likely to be much shorter than the rest of the portfolio (this actually takes a lot of the obsolescence risk out of investment which can occur, but it is not envisaged, in a prime portfolio). Should there be minor defects, then allow for rectifying these by an adjustment in the purchase price, but again you can often do better than expected from tenant recovery by the service charge. Last, do not worry unduly about the covenant strength of the tenants. This is a real issue only if there is a heavy reliance on singular tenants — if in doubt, buy in bulk. The more smaller tenants you have, the lower the void risk.
It is a fallacy that secondary property suffers from greater vacancy in a downswing. It is more likely to be the top of the market new space which takes time to let (at considerably greater loss on lower yields) than an up and let portfolio of older, much cheaper space — and given 25 years’ lease protection you can weather the storm.
To give more specific selection advice: for the retail sector, apply the criteria and seek older, tired shopping centres — where maybe a refurbishment has been tried. The secret is to look for near full occupancy and one that is reasonably busy. The centre will probably have lost the original “anchors” attracted by the pre-opening hype and glitz, and promises of untold wealth.
They will already have moved on to more extravagant surroundings and been replaced by the lower-cost retailers, still often with a multiple branch covenant. The supermarket may well have moved out and been succeeded by those sturdy yeoman of Thatcherism — the market-stall traders. Without exaggerating, they are often very good news for a centre — people like the bartering atmosphere and bargain hunting. Additionally, there is a very low void risk — often a waiting list for pitches, and given a competent centre manager to keep them happy and collect the rent, very little management trouble.
Do not be afraid to look to the frozen wastes of the North. If you suggest the possibility of investing in suburban Birmingham — or Merseyside or Newcastle — you often find a deathly silence on the other end of the telephone, as the horror of what you have suggested sinks in. Just concentrate on the facts: the yield, not uncommonly 10 to 12% initially, and let your managers worry about the tenants. The fact is that the tenants usually welcome a firm hand because they realise it is good for business. On top of the high initial returns there is virtually guaranteed inflationary uplift, and often — can you believe it? — growth.
The other little-loved retail investment is the supermarket tacked on to the end of the High Street. Again, often on a big site, and usually with a well-recognised tenant. These are abundantly available at 8.5% plus and offer good long-term site potential. There is a conception that rental evidence to substantiate growth is hard to come by, which is often true. But the best way to counter this is to buy a good selection and build up specialist expertise so you can fight back on rent reviews.
Again, on the retail/industrial fringes, the second-and-third generation edge-of-town parks mentioned earlier are beginning to look cheap. The original owners are digesting a loss in value and are trading them with considerable difficulty at attractive yields. Buys at 9% will give low site value, often with good road frontages.
On the office front there is a tremendous amount of choice in the 7% to 9% “black hole”. I prefer edge-of-centre, big multi-let tired-looking buildings; the ex boom-then-bust type building which is now full of prosperous local businesses, perhaps with a few more recognised nationals — for instance, branch insurance offices. These buildings consistently follow the coat-tails of the growth in prime city-centre rents, albeit at 50% of the best-achieved levels, and at considerably lower risk. The buildings usually have endless refurbishment potential and will carry on earning their keep for a long time.
As for industrials, these are probably the most difficult to get right. The multi-let estates often have a high vacancy risk as the vagaries of manufacturing come and go, but again stick to the principles of value for money. I do not think industrials will show spectacular growth in the near future — possibly stagnating for another five years before anything happens. Look to buy on high 10%-plus yields; the adjustment of yields outwards is likely to take time. The estates to buy are the ones you wished you had bought before the boom, which are reverting to the old yield levels but now on a higher rent. I still think that the big single-let distribution warehouses offer good value at 9% to 10%, but I would be more tenant aware for obvious reasons.
From my initial comments, the recent performance of property with escalating rents and lowering yields is over — the music has stopped. One way in which to prop up a possibly dull future is to diversify the traditional portfolio into a higher yielding fund.
Apply the selection criteria, be confident in your management and go out and enjoy it. The surprise of unexpected triumphs in secondary property (which happen all the time) make ownership rewarding financially and judgmentally.
