Norman Bowie
It can be confidently expected that 1987 will see the launch of three new property investment vehicles: Property Income Certificates (PINCs), Single-Asset Property Companies (SAPCOs) and Single-Property Owned Trusts (SPOTs).
In addition, the established approved unauthorised property unit trusts (confined until this year to tax-exempt pension funds and charities) may seek to be authorised and become open to all investors.
It is intended that these vehicles will be listed on the Stock Exchange, and that market-makers will deal in the units/shares/stocks.
Investors, both old and new, need to consider whether, under these new circumstances, capital values of investment property will be affected, whether adversely or otherwise.
The value of any property depends primarily on the supply/demand for the accommodation, and from an investment view-point the supply/demand is concerned with the right to own, receive the income and manage. Property is basically a commodity but in a fixed location, unique in design and quality, and subject to a supply/demand balance related indirectly to national and local economic conditions. Each property as an investment is also not only dependent on these foregoing factors, which determine the present and expected income flows, but on its merits in relation to other opportunities in the property market and, increasingly, the alternatives available in the securities markets both at home and overseas.
Direct ownership is lumpy in amounts of capital, changes in income flows come in jerks at intervals of years, dealing and annual management costs are higher than for securities, buying and selling is in matched deals — there are no market-makers — so there is no liquidity, income is secured by the personal covenant of the tenant, there is a 100% distribution, no retentions for asset replacement, reserves or business expansion, nor deductions for management costs.
Tax immune funds for the last 20 years have been able to invest in PUTs, which mostly have mixed portfolios, although a few have specialised either in the USA or Europe or in agricultural land. A not very active secondary market has emerged to make matched deals.
Individual investors also, for the last 20 years, have been able to invest in life assurance policies linked to property with the company making the market. Tax-paying funds have not had any similar vehicle available to them.
All three categories of investors have also had access to the property share market with a wide range of companies of differing size, objectives and abilities. For overseas investment a few UK companies have built up substantial interests, but otherwise UK investors have had to go direct or invest via local companies and trusts.
Property investment has had a poor performance record over the past three or more years compared with that achieved by securities, and some disinvestment has occurred with a low inflow of new money. To improve performance, institutional investors have turned to doing more development deals, whether alone or linked with a developer. The prevalence of high interest rates in excess of development returns has turned developers from long-term holders to traders. Development profits have been squeezed as a result, but developers have had no difficulty in securing finance, either through straight borrowing or with some form of equity or profit participation, with or without an end take-out.
The space market is basically tenant-led except for certain specific locations, and most of those under demand pressure will be eased by the operation of the “feast and famine” cycle.
The arrival of the new vehicles will add to the choice of finance available to developers. Large projects, in particular, may benefit as they will present opportunities for many more investors.
On the supply side the space equation may be affected only to a limited extent by an increase in finance available. Given that the effect on rental levels is unlikely to be noticeable, the tenant’s bargaining position could be marginally improved. Any change will take time to emerge, and will not be sudden.
It is the supply/demand investment equation that is of vital concern, both to existing and new investors. On the supply side the key questions first involve taking a view as to whether the new vehicles will:
see existing investors bringing to the market properties held for some years with a CGT implication, although marginally relieved by limited indexation;
attract owner-occupiers to raise finance other than by the sale/leaseback route;
attract the public sector as a means of releasing capital on town-centre schemes and other commercial properties;
increase development activity as developers find a route enablng them to retain a substantial interest;
afford investors a greater variety of secured and/or equity participating interests.
The promoters of these new vehicles are understandably full of confidence that they will be launched successfully and arouse a sustained and growing demand.
It is the demand side which is much harder to assess, as there is no discernible vocal demand for new property investment opportunities such as that which existed 20 to 25 years ago. It is fair to state that:
smaller funds will now have a much wider choice and a chance to invest in properties hitherto beyond their capacity;
tax transparency will gain additional investors;
a wider choice may be offered so that investors can use selection and obtain their preferred mix;
overseas investors hitherto nervous of direct ownership will have vehicles and a market they can understand;
market-makers will bring in the liquidity which has hitherto been lacking. Dealing costs will be lower and investment timelags reduced.
The main factors affecting the supply/demand conundrum and therefore the price level problem are (one hopes) set out above. Others may occur to readers.
If this wider market arrives, as seems most likely, the key questions are:
will the new vehicles trade at around asset value, or above/below?
will the price of property become more closely related to the perceived net income flow over a period of time?
to what extent will allowances be made for the fact that, unlike commercial companies, no depreciation is set aside nor are any reserves created?
will the perceived rental income with its estimated future levels be valued on a basis more closely related to that of company profits? (viz DCF)
will property values and investment performance move closer to that of equities or index-linked gilts?
will more money come to the market?
will funds treat the new vehicles as securities or direct property for the purpose of sector percentage allocations.
will the market pay increased attention to the fact that rental values decline quite sharply as a building ages when related to a new comparable building?
If property values were to fall this could lead in time to a drying up of new development so that space scarcity would develop, rents rise and the market correct itself, as always (the feast/famine cycle). If property values rise then more space will be created and again the market will correct itself.
The one weakness in the UK property market — the high value of land — might be exposed. This would particularly apply to properties in the lower half of the yield spectrum now spanning 4% to 14%. Any reduction in values and a rise in yields would also, interestingly, align the UK market more closely to the property yields in most overseas markets. The next 12 months could present a fascinating scene for decision-makers and market-watchers.
