The UK commercial property market had a particularly testing 2007, with sharp falls in capital values. While falls in the values of other asset classes such as equities or bonds are common, the fact that prior to 2007 UK commercial property had delivered positive returns every year since 1993 highlights the significance of last year’s poor returns. Although 2008 has started on a more encouraging note, as managers of the New Star UK Property Unit Trust we believe an update on what has happened and what may happen from here may be helpful to existing and potential investors.
What happened in 2007?
A combination of rising interest rates and the credit crunch lie at the heart of last year’s falls in UK commercial property values. Although the UK commercial property market was already slowing prior to the credit crunch its impact was effectively to put a freeze on property transactions as credit dried up. As a result, property was valued primarily on negative sentiment rather than on transactional data. As the value of commercial properties was marked down so was the value of funds that held those properties. The New Star UK Property Unit Trust was not immune; although the value of its properties rose by 1.8% during the first half of 2007, they fell by 17.8% during the final six months*.
A more promising start to 2008
Whilst we are only three months into the new year, there are some reasons to be encouraged. Since the start of the year, the share prices of property companies – an indicator of investment sentiment towards the sector – have performed favourably when compared to the wider equity market. Over the three months to 27 March 2008 property shares, as measured by the FTSE Real Estate Total Return Index, have outperformed the FTSE All-Share Total Return Index by 12.2 percentage points**.
In terms of the values of physical property, the direct property held by the New Star UK Property Unit Trust has fallen 1.86% since the start of the year, compared to a fall of 14.9% in the last three months of 2007*. Although the slowdown in the rate of decline is to be welcomed, we remain cautious on calling the bottom of the commercial property market just yet. Much depends on whether UK economic growth slows significantly from here. We believe overall commercial property returns will remain subdued during 2008, starting to improve in 2009. If the UK economy remains reasonably strong, however, we believe that prime properties at the highest quality end of the market will be one of the first areas to show increases in capital values.
Long-term secure income and diversification
We have consistently stressed the importance of taking a long-term view of commercial property and would encourage investors to focus on the key benefits of commercial property investment: namely a relatively secure income stream capable of growing with inflation and its excellent diversification credentials. Returns from commercial property are generally weakly correlated to those from equities and bonds. This is why many financial advisers recommend that investors hold a proportion of their overall portfolios in this asset class. Holding assets that are weakly correlated to each other is particularly relevant at times of high stock market volatility. In periods of more challenging economic conditions, the rental income from commercial property tenants remains a valuable asset for investors. In these circumstances, companies are likely to cut their dividend payments, which are optional, long before they stop paying the rent on their premises.
As the value of commercial property has fallen, its yield – the value of a property’s income stream relative to its capital value – has risen. The average yield on UK commercial property according to the Investment Property Databank is currently 5.37%†. This compares favourably with the yield on the benchmark 10-year gilt of 4.46%†† and with the current Bank of England bank rate. With further interest rate cuts possible during 2008, not only does the yield available from property look more attractive relative to holding cash or gilts, but it also becomes more cost-effective for potential property investors to borrow money to finance property acquisitions.
Quality tenants on long leases
The New Star UK Property Unit Trust continues to focus on high-quality, modern buildings let to strong tenants on long leases. Even if the UK economy goes into a severe economic downturn, companies such as Centrica, which is the parent company of British Gas, Prudential and Co-operative Group, which are all tenants of properties held by the fund, should continue to pay their rent. The UK government, which is the most secure tenant of all, also occupies a number of properties held by the fund. The average remaining lease length across the fund’s 117 tenants is 12.7 years. Less than 2% of the fund’s properties are currently void, a figure that is low when compared to many other property funds and property companies§.
Liquidity
As the value of bricks and mortar has fallen, some investors in commercial property funds have reduced their exposure to the asset class. Because physical property is less liquid than property shares, this has prompted concerns about whether direct property funds have sufficient liquidity to satisfy the requirements of investors who wish to sell. Indeed, a number of institutional funds and life assurance company property pension funds with low levels of liquidity have imposed restrictions on when investors can sell their holdings. New Star has not done this.
Maintaining sufficient liquidity within the New Star UK Property Unit Trust has been, and remains, an overriding objective for the fund’s managers. The fund currently holds approximately 15% in cash and 9% in property shares, providing sufficient liquidity, we believe, to meet current and foreseeable redemption levels. We believe this level of liquidity is one of the highest in the industry for comparable property funds.
Look beyond the downturn
History shows that falls in UK commercial property do happen from time to time. The last time commercial property values fell as substantially as they did in 2007 was in the early 1990s. Nevertheless, over the last 20 calendar years, a time span that covers both these periods of falling values, UK commercial property has risen in value by 82%§§. If you include the stream of rental income that has also been produced, the total return from UK commercial property has been 628%§§. By way of comparison, the total returns from equities and gilts over the same period were 685% and 422% respectively§§. Past performance is not necessarily a guide to future performance.
The majority of private investors in open-ended funds are typically investing for the long term, often with the aim of securing a reasonable income in retirement. Against these long-term objectives, we believe that investors who hold commercial property as part of a well-diversified portfolio should look beyond the current downturn. Over time, sentiment will improve. Indeed, for prime properties, we believe this may already be occurring. It is worth remembering that the fundamental value of commercial property stems from the long-term rental payments made by tenants. These payments help make it such a useful diversifier.
Investors may take comfort from the fact that some of the largest fortunes in the UK today have been built up and maintained through a "buy and hold" approach to property investment. These fortunes have been created not by property traders who have tried to dip in and out of the market in pursuit of perfect investment timing. Instead such investors – often family dynasties – have believed that "time" as opposed to "timing" has been their ally.
*Source: CB Richard Ellis estimates. **Source: Lipper, net income reinvested to 27.03.08. †Source: IPD UK Monthly Index at February 2008. ††Source: Datastream at 29.02.08. §Source: New Star at 28.02.08. §§Source: IPD UK Monthly Index January 2008 figures to end December 2007. New Star Investment Funds is the trading name of New Star Investment Funds Limited, part of the New Star Marketing Group. New Star Investment Funds is not authorised to give investment advice and only provides information on New Star's products. The simplified prospectus and full prospectus for this fund are available from New Star on request. The telephone line stated above is open from 8am to 6pm, Mon-Fri. For your protection, calls will be recorded and may be monitored. Issued by New Star Investment Funds Limited. Authorised and regulated by the Financial Services Authority.
