London leads a slow, tentative recovery

Investors have been moving money back into commercial property funds, according to fund price data, amid further evidence of improving conditions in the sector.

Signs of a rebound in commercial property values first emerged in August and September, when the Investment Property Databank (IPD) index – the leading benchmark for the sector – registered its first rise since prices began their steep decline in 2007. Since then, buying by investors has started to push up the prices of stock-market listed funds. Two of these, MAX Property and London and Stamford, now trade at premiums of as much as 20 per cent to the net asset values (NAVs) of their property portfolios.

“This indicates the potential a lot of investors see in the sector,” says Tim Cockerill, head of research with the advisory firm Rowan. “One reason is that they all have cash to some extent and are therefore able to buy property. Over time, a revaluation of funds’ property portfolios and increasing rents should see property perform well.”

Other valuation measures also point to a turnaround. Transaction yields on real estate – a key indicator of investment values – fell in the last quarter, for the first time since August 2007, suggesting a recovery in UK commercial property prices. The average yield fell 19 basis points to 7.68 per cent in the third quarter, according to the property group Lambert Smith Hampton.

This is roughly four percentage points higher than the yield on a 10-year gilt and seven times the average return offered by high street savings accounts.

So, even if yields fall further, commercial property funds that can offer 6 per cent in rental income, stabilising capital values, and increased liquidity will continue to compare favourably with other asset classes. At present, 10-year gilts yield only 3.45 per cent, while cash deposit rates hover at around 2 per cent.

Commercial property valuations also offer more potential for a recovery to their historic averages than equities and corporate bonds, which have already rallied strongly. As a result, advisers report increased inflows into funds investing in offices and industrial sites – from investors looking to ride any upswing if and when valuations move from “trough” levels. Prices of commercial spaces in the UK are down as much as 50 per cent from their peak in the 2007 property boom.

An improvement in the commercial lending market has also helped bolster liquidity in the commercial property market.

However, the prices are only responding slowly. “It seems property is still priced for the very worst outlook,” says Cockerill. “Rents on the whole are still heading downwards, but that is very typical at this stage of the cycle. There have been some very good deals available and yields have been very attractive.”

London is the focus of the recovery, which is slowly spreading to other well-let properties in other parts of the UK. Prime properties and retail parks are two of the more desirable areas of the market, say fund managers.

But some parts of the market are faring better than others. Over £1bn- worth of transactions took place in the industrial market during the third quarter, more than double the amount conducted in the previous period, according to Cushman & Wakefield.

Richard Kirby, manager of F&C’s Commercial Property trust, reports that he is buying distribution warehouses in “good” locations. “There’s fierce competition out there for good quality properties,” he reports. “We’ve done two deals totalling about £52m pounds and I’ve been outbid on numerous occasions.”

Others are focusing their investments geographically. New Star UK Property Unit trust’s portfolio is invested mainly in south-east England, for example.

So far, demand has been led by foreign investment, with sovereign wealth funds taking particular interest in the sector, according to financial advisers.

But UK commercial property funds have also raised billions of pounds in recent months, after coming through a period of extensive restructuring.

This month, Legal & General Property, one of the largest institutional property fund managers, announced more than £110m of acquisitions as part of a £600m investment drive. It has completed the purchase of properties in the office, retail and industrial sectors, at yields ranging from 9.1 per cent on a Southampton office building to 7.65 per cent on Waterstones and Game stores on Princes Street, Edinburgh.

However, advisers warn that the market’s fundamentals remain weak – with vacancies still rising and rents under pressure. A large gap also exists between the valuations of prime properties and the less sought-after ones, they point out.

“In most areas, rents continue to weaken and with the likelihood of a further pick up in unemployment, I think that underlying demand for property will remain weak,” concludes Peter Day, a partner with the broker ­Killik. “Landlords are struggling to achieve anything in the way of uplifts at their rent reviews and the increase in value appears to be down to a compression of yields, rather than an improvement in the fundamentals.”