Norman Bowie
There are new players coming on to the fields of the property investment market. Some have merely changed their shirts or colours but others are relatively inexperienced. And, as we have seen, the game itself has also changed with the advent of Thatcherism. So it is a good time to pause and ponder — but not necessarily prophesy — as to the results of these significant changes in the players, their goals, and perhaps the rules.
The global market is here, but in its relative infancy. UK investors have long been merchant venturers, mainly taking their skills and money to North America, Australasia and Europe. Some retired hurt a decade ago, but others have acquired the essential in-depth knowledge of individual overseas markets, with resultant reward. Many of the more successful have ensured that they placed their own people resident on the spot as the only way to have a full understanding of local markets.
The removal of exchange controls, not only in this country but elsewhere, has led to the freedom of movement of capital. The Japanese, with their enormous favourable trade balances, have found it desirable and necessary to permit institutional funds to make overseas investments so as to ease pressure on their currency.
The result of this freeing of the capital markets has meant that the New Zealanders, Japanese, Australians and Dutch are now taking an active role in the UK property market. There are indications that other overseas sources are either present or are undertaking pre-entry studies and research. This mini-invasion may be the precursor of a greater involvement. Some of their early activities have taken the form of joint ventures with British partners or through established quoted companies with a strong British management team. This is the learning-curve process, and it must be expected that overseas personnel will soon take a more direct role at senior management levels.
The landed profession is beginning to feel foreign competition — architects have already lost some ground, including some important projects. It is too early to say whether the new overseas arrivals are here to stay as long-term investors, or are here merely for short-term gain. Our property yields are generally below those obtainable in overseas markets, but they can gain from cheaper domestic money and depreciation allowances in some cases.
The sustained pressure on the investment yields of new properties has in recent years inevitably led to the institutions turning, on an increasing scale, to participating in development as financial partners or becoming developers in their own right. Only in this way have they been able to obtain the higher returns on their invested capital which they need even to start to compete with the performance of equities. The institutional entry on this present scale has been a major force in depressing development profits to an historical low level. Development returns are below the cost of money so that, unless they are traders, developers must be banking on the hope that a mix of inflation and true rental growth will have bridged the gap by the time the first rent reviews arrive. The recent lowering of interest rates, coinciding with the last Budget and election predictions, will have been a welcome relief. It is easier for institutional funds to carry a loss-leader than a developer relying on external finance.
Competition
The competition for development schemes, with lower profit margins and the high cost of money, has not made it easy to create new wholly-owned investments for property companies. Any development activity normally means the ceding of an equity participation — often a substantial slice — to the financier. It is not surprising that under these conditions the new generation of property entrepreneurs decided to become basically traders in order to maintain a flow of profits from which to pay dividends.
The financial characteristics of the current market have coincided with the unpleasant fact that the newly arrived tenants’ market has thrown up the true facts of building obsolescence. In the space of a few years capital values have almost halved on older office and industrial properties. The tax laws are uniquely harsh in the UK as depreciation of the building structure is not generally an allowable deduction. Companies have come under pressure from shareholders to increase dividends every year, so they have not been able to accumulate the necessary resources to replace the wear and tear, but are forced to raise new money by sales, borrowings or share issues.
Even though property investment has underperformed in recent years compared with equities — and sometimes fixed-interest securities — developers have been able to secure all the finance they need in one form or another. The arrival of overseas banks and access to new forms of finance such as non-recourse loans, commercial paper and Eurobonds has more than counterbalanced any drying-up of traditional institutional funds.
The supply side of the market is soon to be buttressed with the arrival of the “born-again” vehicles of single-property companies, single-property owned trusts and property income certificates. No doubt the well-established, approved, unauthorised unit trusts with their property portfolios — the “co-mingled funds” in North American parlance — will also enter the market to present an attractive alternative investment to all institutional and private investors. The investor in the single-property vehicles will still need to buy skilled professional advice on stock selection. The older portfolio trusts have the advantage of affording a ready-made spread and an easier route to achieve some degree of diversification. Perhaps the “fund of funds” concept will be revived: a “flush of PINCs”, “rash of SPOTs” and a “spate of SOPACs” might be promoted by enterprising funds or trusts.
More activity
Under these conditions the supply side of the investment market is likely to increase in size, with more activity by a greater number of traders. This supply will be added to when the vehicles for unitisation/securitisation are launched later this year. A major drop in interest rates is the only likely factor to reduce the volume of offerings, as it might then pay to borrow to hold property — particularly new developments — if margins were to improve. The demand side by long-term investors presents an enigma, because it depends on a restoration of confidence in the property investment markets in that the prospects of rental and capital growth will match those expected of equities or index-linked gilts.
With the return of an expanding economy, and thus a demand for space, the property industry with its higher entrepreneurial stance is responding more quickly. The developer is faced with the question — to build, to hold or to sell? No doubt he will keep his options open until the last moment.
Investors will need to decide whether, in view of these potential supply and demand factors, property investment yields will remain as they are. Or should they wait for higher yields and reduced capital values? One thing, however, seems certain — the market will become more sophisticated, and returns on property will be more closely related to those obtainable in the securities market.
At the end of the day every free market adjusts its prices to match market forces. Some properties are cheap and others are dear. The problem for investors and advisers is to identify them and act accordingly, or perhaps go for cash to await a fundamental adjustment in price levels. But they will need to listen to what the markets are saying — and not what people are saying about the market. It will be interesting to watch from the sidelines, and to see the winning players and their tactics.
