by Peter Evans and Desmond Jarrett
Over recent years there have been major changes in the extent and nature of institutional involvement in the property market. Property has lost ground to other investment media, overshadowed by a long bull run, while portfolio management has grown significantly in importance. The stock market crash has emphasised the need for reappraisal of asset allocation and the substantial rise in returns from property over the last year or so has highlighted its under-representation in many portfolios.
The first article in this two-part study was published in last week’s issue.
Stability in the property market assumes an active long-term investment sector; a role, until recently, seen as the domain of the institutions. Short-term development finance has been available from an increasing number of sources, but the question has remained: would the institutions return in force? 1987 saw the lowest net investment by the institutions in property, in real terms, since before 1970. However, signs of renewed interest in property, apparent in the official figures for the last quarter of 1987, may well point towards a change in direction.
A change in direction poses several important questions — will any increase in property investment follow past patterns? How large will be the revised cash flow? Are funds likely to hold a passive stance in the development sector? In order to address these issues we undertook a detailed survey of fund managers. This paralleled earlier studies by DTC in 1982 and 1985 although our latest survey is the largest so far, encompassing just under £15bn property assets, around 35% of total institutional UK holdings.
Clearly the direction and strength of investment will depend largely on the priorities, objectives and constraints placed on portfolios. Fund managers were asked to list their key investment guidelines. Portfolio structure was the most common guideline with sector allocation and regional spread highlighted by 70% and 40% of funds respectively. Over half laid emphasis on restricting the maximum value of any individual property, while nearly half the respondents indicated that their management was guided by a performance target — a factor that is likely to have an important bearing on investment preferences and methods.
Given the current buoyant performance of property, both in income and capital terms, it is not surprising that almost three-quarters of the respondents considered their 1987 performance surpassed expectations. With the rapidity and scale of recovery, however, there is a likelihood that funds could have seen growth peaking quickly, but the forecasts of future performance demonstrate a broadly based belief that last year’s growth still has some way to go. Just over half of the funds believed property performance would rise substantially during 1988 and would remain high or possibly even rise further over the next two years. This shift in sentiment is further illustrated by property’s superior rating relative to the other major media. The majority of fund managers expect property to outperform all other investments over the next two years.
The optimistic opinion for aggregate performance is reflected in the broad front of strong performance recorded for the individual property sectors. Compared with fund managers’ views in our 1985 survey, there has been a sharp upgrading of both rental and capital growth for West End and provincial offices, as well as industrial and hi-tech property. However, the cyclical nature of the property market is highlighted by the switch in sentiment between 1985 and 1987. With only one or two exceptions those sectors regarded as being on an upward trend in 1985 are now all viewed less optimistically, while the returns on sectors with a very low rating in 1985, such as industrial, are now in the ascendancy.
Standard industrial accommodation and provincial offices have seen the largest change in sentiment. While the current spectacular rental growth of City of London offices, not surprisingly, produced a concensus for falling growth rates, this view was accompanied by a large majority anticipating a softening of City office yields.
Although there is a general view supporting stronger rental growth and firmer yields in the industrial and provincial office markets, retail space is subject to a wider diversity of opinion. Those predicting improving rental and capital growth are balanced by those foreseeing a declining trend. On the other hand, retail warehousing is viewed both more decisively and more positively. While not so bullish as in 1985, over half still expect improving rental growth for retail warehouses and a significant proportion believe that yields could firm.
Belief in the continuation of the recovery of property’s performance over the next couple of years was attributed to the strength of the current economic cycle. Accommodation shortages in many of the major commercial property markets were also, not surprisingly, cited as a major factor. Nevertheless, several fund managers expressed anxiety about the economic scenario that could emerge next year. Concern at the possibility of world-wide recession and its inevitable impact on demand for accommodation was central to this anxiety.
The majority of funds will increase new investment and intend to lift the percentage of money for property over the next two years. A closer examination demonstrates that it is the larger funds which intend to maintain property’s current weighting in new investment. Pension funds, for whom the recent drop in new investment has been largest, overwhelmingly propose an increase in property purchases. Indeed two-thirds by asset value of the pension funds interviewed will increase property’s share of new investment marginally and a further 7% proposed a substantial increase.
It is therefore likely that institutional cash flow for property will rise during 1988-89, supported largely by a marked recovery in new money from the pension funds. Life companies have held property investment within a fairly narrow band in cash terms. Over the next few years the value of new property investment can be expected to rise in line with the sector’s overall investment trend.
Increased weighting is largely attributable to the fundamental strength of the property market rather than a short-term shift. This is supported by the largely neutral effect the stock market crash has had on the investment intentions of most funds. As a result the prospect for further capital and rental growth throughout much of the property market lends additional support to the view that there will be a sustained upward trend in institutional property investment.
The trend towards more active management by the funds witnessed during the 1980s is unlikely to be reversed. The greater emphasis on performance, noted above, carries through to the priority given in terms of method and spread of future investment. Given a choice of acquisition method, the majority of funds would choose to increase investment among the more active options. A high proportion of money is likely to be dedicated to development, either through direct development or the refurbishment of existing buildings. The latter is likely to receive a significantly larger share of new money, reflecting the ageing of institutional portfolios and the increasingly positive approach to improving the performance of individual buildings.
Prefunding has played an important part in institutional acquisitions in the past. Although only a small number of funds intend to reduce this method of acquisition, heavy bank lending and wider access to alternative sources of funding for property companies have squeezed potential profit margins on such deals and reduced dependence on the institutions. This may well be, therefore, a less attractive acquisition method for the funds than in the past.
In terms of a sector and locational breakdown for proposed acquisitions, the funds demonstrate a relatively conservative approach. Retail and southern centres continue to dominate the intentions of a sizeable number of funds. Industrial property has also been given a high priority by all but a small minority. The regional pattern of intended industrial purchases, however, highlights the selectivity of renewed interest in this sector. Almost as many funds intend to buy industrial as retail or office investments in the favoured South, but for certain of the traditional industrial regions the number falls to just one-tenth of those willing to purchase shops. Despite the very large decline in industrial space overhanging the market, the performance of industrials outside the South clearly remains suspect for many fund managers.
High Street shops remain less vulnerable to regional bias with almost half the fund managers willing to purchase across all regions. The provincial office sector is seen as highly attractive albeit with a significant tailing off of interest outside the South. Those willing to buy in the less favoured regions tend to be the large (£100m plus) institutions who intend to invest in almost all regions.
Although West End offices were given a high performance rating and attracted a potentially strong buying level, only one-third of institutions proposed to acquire City offices in the foreseeable future. The expectation of a decline in performance has dampened enthusiasm for City investment, but institutional demand is unlikely to dissipate totally. Investors appear to appreciate the premium value of City offices in a portfolio and are willing to override short-term performance cycles.
Among the remaining types of property, only retail warehouses attracted a significant level of interest. Hi-tech accommodation has clearly fallen from favour. Even in preferred southern regions, such acquisitions are proposed by only a minority of funds.
Although retail investment, particularly High Street shops, should continue to dominate institutional property investment over the next few years, the buying pattern up to 1990 may not be as one-sided as before. Strong investor confidence in offices and a greater flow of new money into standard industrial space should produce a greater balance and a concomitant rise in capital growth in both these sectors.
Underlying short-term fluctuations in the property market is the evolution of active institutional management. The cyclical nature of the property market, changing tenant needs and physical or technological obsolescence of buildings have emphasised the need for active stewardship of property portfolios. In the late 1980s, as the maturity of many portfolios becomes increasingly apparent, there will be greater emphasis placed upon active management processes and a growing percentage of new investment moneys devoted to improving assets.
The results of our latest survey of fund managers lends strong support to the view that a new cycle of property investment has dawned. Over the period to 1990 institutional net cash flow for property is forecast to recover significantly from the depressed trend seen over the last five years. New investment in property should grow at a faster rate than the overall rise in institutional income. In the early stages it is likely to be led by the pension funds while insurance companies increase their involvement more gradually. More important, the recovery is based on the attractions of property’s strong performance rather than being a temporary flight from the difficulties of other markets.
In contrast to 1985’s outlook the latest survey demonstrates a belief in a wide range of property sectors where performance is seen optimistically. This allows fund managers to purchase from a greater range of opportunities, and this wider choice will be an important stimulus to new property investment up to 1990.