by Tim Horsey
This is the final article in a series of four in which IPD review the full results of their Databank on property performance and investment behaviour in 1988 for each of the market sectors.
Offices are central to institutional portfolios; they account for more than half of funds’ property holdings by value. However, in the early part of the decade this level of commitment was not necessarily justified by the returns achieved. Only in the last two or three years have offices become a highly profitable sphere of investment as property values have escalated.
The performance of office property in 1988 surpassed that of the previous year, reaching new peaks in terms of all the main growth indices. Once again it substantially outperformed the retail sector, the other main sphere of institutional property investment. The continuing expansion of financial and business services through the 1980s, both in terms of output and employment, has laid the foundation for the rise in values, despite an equally impressive growth in the rate of new development. And last year high returns spread beyond the bounds of the capital, within which they had been largely confined during 1987.
Total return on the office properties surveyed by IPD (valued at £9.7bn at the end of 1988) stood at 32% for the year, more than 4% up on the 1987 performance. Their capital growth was overtaken by industrials for the first time during the decade, but rental growth at 27.7% was above that in the other sectors. This bright picture was clouded somewhat by gathering inflation that reduced real total return to 22.7%, slightly below that of 1987.
Regional returns
London, and the City in particular, no longer enjoyed the massive lead in performance which they had established in 1987. Although returns in London again led those in the “prosperous” South and the rest of the UK, the spread of total returns achieved across these three areas diminished from 22% to 6%. Ratio of capital growth and total return on London office properties actually saw a decline in 1988 from the peak of the previous year.
This fading in London’s performance was due entirely to returns in the City. In 1987 the financial centre represented easily the best part of London (and indeed the UK as a whole) in which to hold office property, attaining a total return of nearly 40%; the West End followed fairly closely with 35%. Last year the position was more than reversed, with capital growth in the West End nearly twice that witnessed in the Square Mile. Performance in suburban London was also superior to the City’s for the first time in the 1980s.
Such was the cooling of the City market that a number of regions outside the capital also witnessed superior returns: the South East, the Midlands and the North all shared in the boom to a much greater extent than they had done in 1987. Leeds, Manchester and Nottingham produced returns of 42%, 32%, and 28% respectively.
Relative investment performance
Having run for so long in the shadow of the retail sector, 1987 represented a watershed for offices, with returns surging ahead of shops. For every previous year in the 1980s considerably higher total returns were achieved by a portfolio of retail and industrial properties taken together with the actual weightings they had among IPD funds each year. This relative return is shown in Table 1.
Offices’ best relative return during the decade so far was recorded in 1987, when City offices achieved their peak performance with retail and industrial property lagging far behind. Last year saw this advantage eroded to some extent as industrial total return shifted from 7.5% behind offices to 7.6% ahead, and retails’ lag behind offices has diminished from 9.5% to 7.6%. The IPD Monthly Index suggests that this pecking order is likely to continue in the near future: office rental growth was running at an annualised rate of 16% during the first quarter of this year with retails on 11% and industrials marginally ahead with 17%.
The differential in returns between offices and other property may be further analysed by dissecting it into components:
- The difference in income return — for offices this has varied from a small negative figure early in the decade to somewhere around parity in the last two years.
- The difference in rental growth — ie that part of relative capital growth which is due to ERV movements; this reached its nadir in 1984, but by 1987 had become the most crucial element in the sector’s strong performance, as rents leapt in the London market.
- The additional part of changes in capital values caused by shifts in the office yield in relation to the other sectors: between 1983 and 1986 office yields moved out, and although this was reversed to some extent in 1987, 1988 again saw a lengthening of office yields relative to other sectors.
To give an impression of the investment consequences of holding office property during the 1980s one can combine these annual figures to form an index (Figure 1), which again shows the total return measure split into the components described above. This indicates that the relative performance of offices has been turbulent, and has left them with a marginally lower overall return since 1980 than an alternative office portfolio despite the revival of the last two years. The movements of relative ERVs and yields which contributed to this were not very consistent; rental growth was below par in every year between 1980 and 1985, and from 1982 relative yields were lengthening. However, from 1986 this was followed by a dramatic improvement in rental performance which was not accompanied by any great movement in relative yield.
Institutional office investment
During the 1980s the proportion of institutional portfolios devoted to the office sector has declined significantly, from 59% of property value to 53%. The bulk of this shift occurred between 1983 and 1985, which was also the period during which the sector was experiencing its worst performance. It resulted from two factors: first the proportion of net investment in the sector by institutions was lower than the proportion of assets held in the sector during these years; and, second, capital growth was relatively stronger for non-office properties.
These effects are illustrated in Figure 2. It can be seen that between 1981 and 1986 both relative net disinvestment and relative value decline combined to shrink offices’ share within portfolios. In absolute terms net investment in the sector by IPD funds followed an almost continuous decline from £430m in 1981 to minus £66m last year. This withdrawal from offices has continued despite the recent revival of its performance.
There was a considerable variation between different types of fund so far as shifts in the sector split of their portfolios were concerned. Insurance companies, which account for more than half of the Databank’s value, have maintained a consistent level of commitment to offices at just over 62% of total holdings. Pension funds were most responsible for the decline in offices within the whole databank, as their portfolio share diminished from 60% to 40%. This corresponded almost exactly with the rise in retail holdings among such investors; these institutions have adopted a clear policy to readjust their sector weighting in line with their performance experience during the 1980s. Over the decade pension funds’ retail properties have produced a total return nearly 4% above that of their offices on an annualised basis; this contrasts with insurance companies, which obtained a much closer return during the period (see Table 2).
Perhaps surprisingly most of the net disinvestment in offices has been witnessed in the London market; net outflows of £40m and £93m took place in 1987 and 1988 respectively. This represented a marked contrast to the early 1980s, when the great bulk of positive investment in the sector was concentrated in London. Meanwhile, the South outside the capital has seen a consistent if relatively low level of positive net investment throughout the decade.
Offices’ contribution to institutional returns
In the early 1980s offices did not contribute so much to overall fund returns as their weighting in portfolios might have implied because of their inferior returns relative to retails. As can be seen from Figure 3, from 1983 to 1985 they produced less than half of all returns despite accounting for well over half of Databank value. And within the contribution made by offices income return was a much more crucial element than capital growth, outweighing it by a factor of four or five to one between 1982 and 1985.
In 1986 signs of the coming boom for office property began to appear; capital growth showed signs of revival, while the contribution of the sector to overall returns exceeded that of retails.
In 1987 offices provided a very large proportion of all institutional returns due to the massive rise in capital values. And within this capital growth component London constituted by far the most crucial region: capital growth in London offices accounted for 46% of total fund returns in the 1980s.
Last year saw a slight modification in this picture, but despite London’s deterioration in returns, it continues to dominate investors’ returns. Capital growth in the South and rest of the UK played a more important role than in the previous year, while industrials for the first time assumed a place of some importance in portfolio profitability.
Office prospects
Institutions began the 1980s with a heavy weighting of property value in the office sector; however, the state of the market and a consequent growing reluctance to invest in the sector meant that when the boom eventually occurred funds were not in so good a position as they might have been to take advantage of the surge in values which took place. Moreover, the implications of investment activity in the sector over the last two years is that institutional investors do not expect the boom to continue unabated, or at least that they have cornered all the more secure niches of the market.
The office sector has seen a huge growth of supply in response to the boom of recent years; however, at the national level, the increase in the supply of floorspace which has resulted has not outpaced growth of financial and business services which has taken place. Nevertheless, the supply-demand balance varies markedly at a regional level; construction orders in London and the South East are up by more than 100% over their trend rate, while office development has been very limited in East Anglia, the East Midlands, the North and Wales; these regional markets would appear to have relatively positive prospects.
Overall the climate in the office sector looks more favourable than that facing retails; the expansion of supply has not been unjustified when viewed in the light of total business service expansion within the economy. And the economic slowdown now under way seems likely to hit the office market less severely than either of the other two sectors.
