How to make money in the commercial property market

Here’s a pleasant surprise from Britain’s commercial property market.

Over the past year, landlords have received 2% more income from their retail properties, says the Investment Property Databank (IPD). In contrast, incomes from offices and industrial buildings have dropped by about 1% during that period.

We’ve been gloomy about UK commercial property prospects for ages. And particularly retail property.

So does the latest IPD data suggest it’s time to change tack? And what’s an indirect way of making money from commercial property?

Commercial property has been hit hard

For most investors, the UK commercial property market – offices, warehouses and shops – has been a disaster zone for the last four years. Average prices across the sector have plunged by over a third from their mid-2007 highs. The Great Recession has really taken its toll on building values.

Further, the share prices of quoted real estate investment trusts (REITS) have been crushed. In January 2007, most of Britain’s major commercial property companies converted to REITS for tax reasons. Since then, shareholders have lost almost two-thirds of their money.

Indeed, stock market investors in the sector have made precious few overall capital gains since 1993. But there’s been a bit of a revival in the price of commercial bricks and mortar over the last two years.

Average values in the sector have climbed by almost 18% since their summer-2009 lows. And some parts, like central London office space, have enjoyed a purple patch.

So if retail property incomes have also been making a comeback, this poses a couple of questions. Will commercial prices now interest possible bargain hunters? And should you be buying REITs?

Are we at the bottom of the market?

In fact, this now looks about as good as it gets for UK commercial property. The pick-up in prices is losing steam fast. The last quarter saw by far the smallest climb in overall values since the recovery began. Over the last year, capital growth has slowed to just 1.7%.

What’s more, the outlook has just got a whole lot worse. The RICS commercial property survey tracks what the people at the coalface – Britain’s property surveyors – are seeing. It’s a well-watched guide to future price prospects. And the latest report has just gone very glum.

During the first six months of 2011, the RICS surveyors reported increases in occupier demand across the board. But last quarter, demand went negative everywhere. That was despite further cut-price rental deals in every sector.

The biggest dip in demand was in the retail arena. Here the RICS balance dropped from a nicely positive figure in the second three months of 2011 to the worst reading in the third quarter since mid-2009.

Less demand means more unused property. There was a widespread increase in spare space. Once more, retail saw the biggest increase. Again it was to the highest level since mid-2009. No wonder near-term rental expectations went sharply negative.

In fact, even the best bit of the market is going sour. The RICS survey suggests the Central London office market has topped out. Occupier demand has plummeted, as have rental expectations.

The wider picture is gloomy

That’s bad enough. But now a return to recession is looming. Yesterday served up more evidence of this. Britain’s biggest trading partner is the eurozone. Here, both manufacturing and service industries are shrinking at their fastest for two years, says economy watcher Markit.

Meanwhile in the UK, already cash-strapped consumers will have to curb their spending even more. That will mean more retailers going out of business. Business generally will suffer. Financial firms will lay off more staff. And landlords’ overall rent receipts will shrink.

“The survey did nothing to ease concerns that over the past three months, the risks of a renewed economic recession and a second downward leg for rents have grown sharply”, says Kelvin Davidson at Capital Economics. “Our forecast is that office rents in the capital will start to fall again in 2013. If anything, the latest RICS data suggest this downturn may come through a little sooner”.

There’s similar stuff from the latest Lease Events review from Strutt & Parker (S&P). Further, the latter also contains more potential gloom for landlords. Where vacated properties haven’t been re-let quickly, S&P’s data suggest they could stay empty for a long time.

Why is this crucial for the commercial sector? Buildings are valued on what they can earn in rent. So the worsening rental picture, added to more empty buildings, is clearly a bad omen for valuations.

“We’ve now cut our expectations for UK commercial property returns next year”, say Davidson. “We now think all-property capital values could decline by about 5%”.

That sort of drop would hit REIT share prices once more. Since we last wrote about UK commercial property two months ago, REITs have undershot the broader market by some 7%. As the outlook gets worse, the underperformance looks set to continue.

There’s still a way to make money

But in August we also suggested another way to make money from commercial property. However bad things get, landlords must still keep up insurance cover on their assets. So why not buy shares in the country’s largest property insurer?

RSA (LSE: RSA) is one of the world’s leading insurance groups. It has reduced its overall risks levels by diversifying widely.

The share price has nudged up a couple of pence in the last two months. But it’s still one of that exclusive club of stocks with p/e ratios lower than dividend yields. RSA is now on a current year p/e of below eight, while the prospective yield is 8.3%.

That sort of value, though, may not be around for too long. As broker Daniel Stewart points out, it’s now a takeover target with at least 25% upside. RSA is cheap whichever way you look at it.

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