The best way to profit from commercial property today

At first sight, things seem to be looking up for the UK’s commercial property market.

In the first quarter of this year, while Britain’s financial institutions dumped both gilts and equities, they were net buyers of commercial property. They increased investments in the sector by almost £500m.

This was no blip. In fact, it was the tenth quarter in a row of net buying. And as property values are ultimately driven by weight of money, you might expect this cash inflow to herald an upswing in prices.

So should you follow the institutions into the property market?

In short, no. But that doesn’t mean you can’t make money from commercial property – I’ll explain how in a moment…

Any commercial property recovery seems to have stalled

The UK’s commercial property market – offices, warehouses and shops – has been a very unhappy place for investors in the last five years.

In the boom times the sector was flying high. To take advantage, at the start of 2007 most of Britain’s major commercial property firms turned into real estate investment trusts (REITs) for tax reasons.

But this move also came within a few months of marking the very top of the market. Recession clobbered building values, which have plunged by around a third from their mid-2007 highs.

Since REITs were introduced, shareholders have lost half their money. Indeed, on balance, investors in the sector have made hardly any capital gains since 1993.

There’s been something of a rebound in property values from the summer-2009 lows. Central London office space in particular has rallied well. Prices have recovered by almost 50% and are now just 20% below the 2007 peak.

But the recovery seems to have stalled.

After being net buyers for ten quarters in a row, according to data for April and May from industry watcher Property Archive, UK institutions have started selling out of commercial property again.

History shows that these periods of net selling have coincided with falls in property prices. And in fact, the latest CBRE monthly index shows capital values dropping by 0.5% in June, after a 0.6% decline in May.

So what’s in store for the sector now? The short answer is it doesn’t look good.

Office vacancy rates in London are edging up. And financial services firms’ confidence about their general prospects has slumped.

With the UK and Europe both in recession, more job losses in the financial services sector are likely. That would batter demand for office space, which suggests that rents will stop growing too. In turn, that will be bad news for capital values – commercial properties are effectively priced off the rents they can achieve.

Things look even worse on the industrial side. Economic growth has always been the best guide to industrial property rents. If Britain’s growth remains weak to non-existent, then fewer tenants will want to hire commercial space. More businesses will have to cut back. Some will go to the wall. Either way, further falls in industrial rental levels have to be on the cards.

As for general retailing – don’t ask. My colleague Phil Oakley wrote recently  about the ‘fixed charges’ – which include rents – that retailers have to shell out before they can make any profit.

If a firm can’t afford these fixed charges, then in effect it’s out of business. And with the outlook for UK consumer spending grim, more general retailers are likely to find it even tougher to pay their fixed charges. Again, some will be forced to close, hurting landlords’ rental incomes.

The economy can’t support a healthy commercial property sector

The professionals in the market seem to agree that the outlook is gloomy. One of the best guides to the future of the market is the RICS Commercial Property Market Survey. It shows that a majority of surveyors saw demand fall in the second quarter, despite landlords offering more letting incentives. Meanwhile, overall available space grew for the 21st quarter running.

Britain’s bankers aren’t keen on commercial property either. In May, net lending to the sector was negative again for the sixth month in a row. It’s set to stay that way, reckons Kelvin Davidson at Capital Economics.

“With wholesale funding conditions tight and the economy weak, commercial property finance is likely to remain tight”, he says. “We expect all-property capital values to fall further, perhaps by another 4% to 5% over the rest of this year and by 1% in 2013”.

So with rentals under pressure too, it still doesn’t sound like a great time to invest in REITs.

But don’t ignore the sector altogether. There’s a way that smart investors can profit from commercial property without getting too much exposure to the market itself.

However bad things get, landlords still have to maintain insurance cover on their assets. That’s good news for RSA (LSE: RSA), the country’s largest property insurer.

I wrote about the stock a month ago for readers of The Fleet Street Letter. Although RSA has risen since then, it still looks cheap on a current year multiple of 8.2 and prospective yield of over 9%. And if you’d like another way of playing RSA that’s currently yielding almost 7%, Phil writes about one here: Seeking income? Try these four preference shares.

Category: Economics