Standard Life Savings & Investment Ezine

Standard Life's Savings & Investment newsletter for advisers

Issue 1: Oct 2006

Past performance is not a guide to the future. The value of investments can fall as well as rise The views expressed in this article are those of the author and do not necessarily represent the views of Standard Life.

Commercial property has returned to favour over the last few years for a number of reasons. A key driver was the sharp decline in equity markets at the start of this decade, which prompted many investors to seek alternative means to help achieve their objectives.

Historical performance
Commercial property returns have historically had a low correlation with returns from equities and bonds, since the asset class does not necessarily react to market or economic conditions in the same way or at the same speed. This can increase diversification within a balanced portfolio, reducing overall risk and enhancing potential for higher returns. Property returns have also been less volatile that those of equities and bonds and between 1981 and 2005, annual all property returns have been negative in only three years out of 25 (Source: IPD Digest 2006).

Attractive to investors
In addition to portfolio diversification benefits, commercial property is a compelling investment in its own right, since it offers an attractive combination of regular income and potential for capital growth, encapsulating the characteristics of both equities and bonds. Property also offers the potential for a higher and more secure income yield although investment in property is less liquid than equities. The majority of commercial property leases allow upward-only rental reviews, which, when combined with long leases to quality tenants, means that a consistent level of income can be maintained, regardless of market conditions.

The asset class itself offers significant scope for diversification. The UK market is vast, with assets of over £330 bn (source: IPD March 2006), giving investors opportunities to diversify in a number of ways. The three main commercial property sectors – Retail, Offices and Industrials – all offer particular opportunities and varied risk profiles. Different locations, property types and number of tenants are also key factors in enabling investors to spread their risk.

Why continue to invest in property?
Commercial property remains a compelling investment opportunity for the reasons noted above. Following several years of very strong gains, the level of overall returns is expected to slow from 2007. However, we still expect solid returns in the region of 7 to 8% per annum over the next five years. This also compares favourably with the outlook for equities and bonds for the next year or so. With global economic growth expected to slow in 2007, we are unlikely to see such high returns from equity markets as in recent years. Meanwhile, the global bond markets have enjoyed strong performance in the last decade and most now offer relatively low yields, meaning that there is fairly limited scope for significant gains from bonds.

Property outlook
Having returned an annualised 20% in the seven months to July 2006, commercial property is on track for another year of strong performance and we are currently forecasting all property returns of about 16%. Despite some upwards pressure on inflation and interest rates, stronger economic growth remains supportive of further rental appreciation. We expect property in the South East to outperform the rest of the UK market, given its higher exposure to Offices and service sector employment. The London market in particular should benefit from strength in the service sector and growth in tourism.

Strong investor demand for commercial property in recent years has pushed prices significantly higher - and yields have fallen correspondingly. Looking to 2007, we expect returns from the overall property market to moderate to about 7%, as falling investment yields make a smaller contribution to total returns than in recent years and performance will increasingly be driven by rental growth. However, performance is not expected to be uniform, which therefore presents opportunities to outperform the wider market. For example, we expect prime (high-quality) properties to outperform secondary, riskier assets as the latter are beginning to look overpriced. At the sector level, Offices should outperform Retail and Industrials. There will also be opportunities within the sectors – we are particularly positive on Central London offices and retail warehouses – as well as compelling stock-specific investments across the market as a whole.

Adrian Little, Director - Indirect Property, Insight

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