by Tim Horsey
Investment returns in the retail sector have been overshadowed by those on offices and industrials over the last two years. It is perhaps easy to overlook the fact that retail increased both its nominal and real returns in 1988 to historic peaks. It remains, by a comfortable margin, the best performing property sector of the 1980s — and is now the dominant investment choice by the institutions, capturing over 90% of their net investment over the last two years.
Throughout 1988, high returns for retail property were underpinned by the further surge in the consumer boom; over the year consumer spending was up by a record 6.5%, despite signs of a slowdown toward the end of the year.
Institutionally owned retail properties in the IPD (covering £6.7 bn worth of retails at the end of 1988) showed a total return to investors of 24.5%, up on the 18.4% achieved in 1987 and more than double the 11% of 1986. After allowing for inflation, real returns were up from 13.7% in 1987 to 16.1%.
In both of the last two years, returns on retail have fallen behind those on office and industrial property, but it remains the leading investment sector of the 1980s. Annualised retail returns from 1980 of 15.3% pa (8.8% pa in real terms) lead those on offices by 1.7%, and those on industrial by 2.8%.
These last two years, fading relative performance for retails has been driven more by the investment markets than by differences in the performance of the user markets — ie the product more of shifts in capital values than in rental growth. From 1986 to end-1988, the growth in retail rental values has been 42%, compared with that for offices of 56% and industrials at 38%. The growth in retail capital values of 34%, however, has been only half the 69% seen by both offices and industrials.
Investors have clearly shifted to a far more favourable valuation view of the office and industrial sectors, with only a marginal change in their assessment of retails (at least up to the end of 1988) — although, as we shall see, this change in market sentiment has not been reflected in their allocation of new investment.
Across the country
Across the regions, retail performance in 1988 showed a far more even pattern than in 1987. Through the 1980s, London and the South have generally shown the best performance. The take-off in rental values and total returns in 1987 was again led by London, which saw a return of 25.8% in that year, with the rest of the South lagging six points behind, and the rest of the country six points again behind the South.
But in 1988, these three areas of the country showed remarkably consistent total returns, all between 24.4% and 24.6%; as London’s performance fell back a little, that in the South improved and that in the rest of the country leapt by 10 percentage points over its 1987 showing.
Last year was, therefore, the year of the Midlands and Northern provincial centres in the retail investment market. Towns such as Nottingham, Manchester, Leeds and Leicester showed returns ranging from 30% to 50%, strongly outperforming London and cathedral cities like York, Chester and Norwich, much favoured by investors.
Relative investment performance
Retail investments have now seen a marked shift in their relative performance against other property. Total returns were higher than for both other sectors in every year from 1981 to 1986; in the last two years, they have fallen behind by a widening margin. On the latest evidence, this differential is likely to persist in 1989: the IPD Monthly Index shows retail rents running at an annualised rate of 11% in the first quarter of this year, against 16% for offices and 17% for industrials; slower rental growth is, moreover, being compounded by a lengthening of yields. Those who take a gloomy view of medium-term prospects for consumer spending may expect retail under-performance to run on beyond 1989.
To look at the relative rise and fall of retails in more detail, we have broken down the difference in total return each year between retail investments and all other property held in the IPD. Thus, Table 2 shows that retail total return was 3.9 percentage points higher than office/industrial property in 1981, and 8.7 percentage points lower in 1988. This difference in total return each year is split into three components:
- The difference in income return — which shows a retail income return consistently lower than for other property.
- The difference in rental value growth — which shows consistently higher rental growth for retail from 1981 to 1985, with a deterioration over the last three years.
- The additional part of changes in retail capital values generated by shifts in the retail yield against other properties — which shows very large contributions to retail’s relative performance in the period 1983 to 1985 as office and industrial yields moved out, and the reverse over the past two years.
The annual measures given in Table 2 have been compounded into a relative performance index in Figure 1, giving indices of retail total return against other property, again split into the three components of difference. What the index demonstrates are the benefits (or otherwise) to investors of holding retail properties in their portfolios against alternative investments in office and industrial property. It brings out dramatically the investment consequences of retail’s consistent out-performance of other property in the first half of the 1980s.
By the end of 1986, retail holdings were showing an accumulated total return 31% above other properties. Lower income returns meant that this component of performance had reduced retail performance against other property by 5%; but rental growth had risen above the other two sectors, and a favourable shift in yields had each made a contribution of nearly 20% to the sector’s relative return.
Equally dramatic is the rate at which this advantage has been eroded in the last two years: the retail sector’s margin of total return over the other two sectors has fallen to 12%, as the lower rate of income return has widened to 8 percentage points, while rental values and yields have both turned in favour of other properties.
A further feature of the chart is how closely movements in retail yields relative to other property have tracked those in rental values, suggesting that the investment markets have reacted rapidly and consistently to year-on-year shifts in the rental performance of retail against other sectors.
Responses by the institutional investors
High returns on retails relative to other property investments have been matched by the enthusiasm of the institutions for investment in the sector. Over the 1980s, the funds have seen the proportion of their portfolios in retails increase from 25% to 36%.
This enthusiasm has extended across all types of fund in the IPD, but has been most marked among the pension funds, which have doubled their weighting in the sector from 20% in 1981 to 42% by the end of 1988. Short-term funds (PUTs, unit-linked and managed pension funds) have shown an increase from 35% to 40%, while among the traditionally cautious insurance funds the response has been more muted, with retails rising from 23% to 28% of holdings.
The shift in fund portfolios towards retail is the result of two factors:
- shifts in capital value, where growth in retail values above or below other property will increase or decrease its share of holdings;
- and relative investment, where commitments of net investment above or below the share of retail in the existing portfolio will increase or decrease its share of holdings.
Figure 2 separates the influences of these two factors on the retail proportion of portfolios from 1981 to 1988. It shows that the retail share grew by 1% or more per year from 1982 to 1986, and has since levelled off.
Up to 1986, the larger part of this growth was the product of growth in retail capital values above office and industrial, a trend reversed over the last two years.
What is notable about the chart is the consistency of the trend in the institutions’ investment. Since 1982, retail has had the lion’s share of net investment, adding 0.5% or more to its share of portfolios every year. Over the last two years of fading retail performance against other sectors, its share of investment has in fact increased, and the continued preference of the funds for shop properties has wholly offset a fairly steep decline in relative capital values.
Retails and returns to the institutions
We have seen that retails have grown dramatically in importance within the portfolios of the funds: Figure 3 shows how much they have contributed, each year since 1982, to the total returns received by the funds, breaking retail returns into components of cash income, and growth in investment values.
As a result of poor or negative returns and low capital growth in other sectors in the first half of the 1980s, the income return on retail properties accounted for a large fraction of fund returns up to 1986 — around one-fifth. At their peak of relative performance, returns on retail investments accounted for half of the total return received by funds.
With generally high capital growth boosting returns, that fraction has now fallen below 10%; capital growth on retails, however, has steadily accounted for a fifth to a quarter of total fund returns.
Overall, the recovery of the other sectors has made fund returns far less dependent on the fortunes of the retail sector: in 1988, for example, the capital growth on London offices alone accounted for nearly 40% of the total return to property investors.
Retail investment prospects
As we have seen, the strong investment performance of the retail sector against other property through the 1980s — and indeed its good relative performance running back into the 1970s — has been matched by extremely strong investment interest by the funds. But as they have geared up their retail holdings against other property, the peak of relative performance has already passed.
All the indicators of the likely performance of retails over the next couple of years against other sectors seem to point down. The Chancellor’s current strategy bears down on retail spending, and may cut the growth in expenditure to only 2% a year by the turn of the decade — one-third of the recent rate. At the same time, the rate of retail development, currently running at two and a half times its long-term trend rate, is moving towards an even higher historic peak.
The fascinating question for the medium term, therefore, is how far the funds will maintain their attachment to the retail sector on account of its long-term performance and reliability, or how far funds may begin to switch to other sectors on the basis of their more recent performance.
This article is based on tabulations and commentary in the IPD Investors Property Digest and Monthly Index; subscription to the two services is £1,750 from IPD, 7-8 Greenland Place, London NW1.
