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Variations on a theme - volatility of returnsBy: Richard Shepherd-Cross

Richard Shepherd-Cross, Mattioli Woods

Over the past two years commercial property values have recovered, stabilised and now sit comfortably against long-run averages. As with all generalisations, this statement stands to be knocked down, but as a generalisation, when qualified for well-let, prime and strong secondary, properties it stands up to scrutiny.

While the market experienced a very volatile period through 2007-2009, characteristically, property investment returns offer low volatility. For the year to April 2012 the Investment Property Databank (IPD) reported total returns of 6.1 per cent for commercial property investment.

Meanwhile the FTSE All Share Index fell 5.05% over the same period. As the chart below shows the FTSE saw average daily volatility 0.98 per cent with the high and low point of the year separated by 27.5 per cent.

The low volatility of commercial property returns is the result of various factors, which combine to deliver the characteristic property performance:

  • Limited trading activity compared to other asset classes. Annual average property market turnover is £36.5 billion which is only 10% of a typical quarter’s turnover in the equity and bond markets. Property acquisitions tend to come about as a result of a long-term strategic plan rather than as a speculative opportunity, as a result of market mispricing. With no central market place providing a daily price for properties it is not always possible for many investors to identify mispricing in the market other than retrospectively.
  • Long lease contracts provide investors with a predictable long-term cash flow, often secured against strong or undoubted tenant covenants. This is coupled with a market-standard rent review pattern, with rents reviewed every five years on an “upwards only” basis maintains short term rental levels. This de-risks the forecast cash flow and reduces the volatility of income.

Investors in commercial property can further reduce volatility through diversification. Diversification across a number of property types, locations, tenants and lease expiries, as is typical in most property portfolios, will significantly reduce volatility of returns.

  • In the market at present, retail yields have softened as office and industrial yields have hardened.
  • While the central London office investment market, south-east industrial markets and major regional centres (Birmingham, Manchester, Edinburgh etc) prime office markets are strong, small regional shopping centres and northern secondary office and industrial markets are weak.
  • The variance in performance is not just down to location or property type, there is also a spread between prime and secondary properties.
  • A further overlay of diversity is offered by the very broad range of tenants and their relative financial prospects.

It should be possible to build a portfolio of properties, with sufficient diversity to iron out the worst of the volatility, that produces a stable net income return of 5%-6% plus and some prospect of long-term capital growth. This should provide ungeared total returns of 7.5% plus overall. While property may be more illiquid than other asset classes, as the cornerstone of a well-diversified investment portfolio, property can deliver secure returns, with low volatility. While there are times when this will not prove to be a robust strategy, over the long-term, the return characteristics of property should hold good. Of late property has delivered some solid defensive returns. A recent article in Money Observer stated: “The property sector has little correlation with equities and bonds, meaning in times of volatility, commercial property can help to preserve wealth.” In fact, over the past ten years the correlation coefficient of commercial property and the FTSE 100 has been only 0.25%.

Do not assume that there is never a sting in the tail: by way of an example, nothing short of a total exit from property could have smoothed the very volatile period from 2007-2008 when the market fell over 40 per cent and then corrected by almost 20 per cent in 2009-2010. However, based on current market pricing and consensus forecasts, property is likely to continue to provide stable income returns with capital values growing slightly, on aggregate, across the market over the next few years.

Any forecast of total return will reflect the importance of income in the composition of total return. As the chart below shows, the income return has for the past ten years fluctuated, but has on average returned 6.08 per cent per annum and is currently 6.1 per cent per annum. This is comparable to the early 2000s when the market was on trend. We are not forecasting a repeat of the market volatility of 2007-2009 when in retrospect it can be seen that the market was at first, too expensive and latterly too cheap.

Year IPD Income Return
2002 6.9 per cent
2003 6.8 per cent
2004 6.3 per cent
2005 5.7 per cent
2006 4.9 per cent
2007 4.6 per cent
2008 5.6 per cent

The case for commercial property investment as a shelter from the volatility of other markets remains persuasive. As the market continues to experience a low interest rate environment, with low bond yields and uncertain short-term equity returns, the secure and relatively high income return from prime and good secondary commercial property remains attractive and should form part of a well-diversified investment portfolio. 

About the author

Richard Shepherd-Cross is Head of Property (Managing Director) with Custodian Capital.

Richard is a Chartered Surveyor having graduated from Reading University in 1994 and attaining the MRICS qualification in 1996. Prior to his role at Custodian Capital, Richard was a director at Jones Lang LaSalle in London, running a team focused on portfolios of commercial investment property and while at Mattioli Woods, he had responsibility for the syndicated property initiative, developing the service into the subsidiary, now known as Custodian Capital. He has experience across the national commercial property market and all commercial property types, with a strong focus on investment.

Features August 2012

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