The best way to play UK commercial property

Britain’s commercial property sector breathed a sigh of relief last week. The Budget didn’t contain any nasties for the country’s industrial landlords.

On top of that, official data showed that during the final three months of 2011, financial institutions made net commercial property purchases of more than £800m.

That was more than double the figure from a year earlier, and was also the highest total since 2010’s second quarter.

So is all this a sign that the commercial property sector is bottoming out? Should you now be holding property shares in your portfolio?

The short answer is no. But there is another play on the sector that looks far more attractive.

Commercial property’s rally has been short-lived

The UK’s commercial property market – offices, warehouses and shops – hasn’t been a happy place for most investors in the last five years.

Back in January 2007, the sector was flying high. That was when most of Britain’s major commercial property firms converted into real estate investment trusts (REITs) for tax reasons. But that move also came within a few months of the market topping out big-time. 

The Great Recession knocked the stuffing out of building values, which have plunged by more than a third from their mid-2007 highs. Meanwhile, since REITs were introduced, shareholders have lost around 55% of their money. Indeed, on balance, investors in the sector have made precious little in the way of capital gains since 1993.

To be fair, the value of commercial bricks and mortar has picked up a bit – around 17% – from the summer-2009 lows. And some areas, like central London office space, have enjoyed a purple patch for a while.

But this recovery is now stalling. In February, prices dropped for the fourth month in a row.

What’s been the problem? “Weakening occupier demand underlies this month’s fall in values”, says IPD boss Phil Tily, “and outside London this is now having a notable drag on performance”.

In other words, fewer tenants want to hire commercial space. Even in Central London, the take-up of office space has fallen back this year – it’s now down about 25% year-on-year. Lower demand for space means lower rents. And as buildings are priced on the returns they generate, that’s led to a drop in valuations. 

Conditions will only get worse

The problem for the sector is that the outlook is getting worse. People will only want to rent more offices and warehouses if the economy starts to show signs of improving. At the moment, that’s just not happening. In fact, it’s doing the opposite.

Industrial production is weakening – in January it dipped 0.4%, reversing a 0.4% gain in December. As Chris Williamson at Markit has noted, this “casts some doubt on the ability of the economy to pull back from the downturn seen in the final quarter of last year, and the spectre of a double-dip recession will be kept alive by these numbers”.

In addition the country’s dole queues are getting longer again. UK unemployment is now at a 17-year high. That means the potential demand for commercial property is set to keep dropping.

Then there’s the government’s austerity programme. With more public sector job cuts on the way, the authorities’ demand for office space is set to decline further. What’s more, the state is selling off surplus assets, which is adding to the supply of property on the market.  

As for the high street, retail sales fell by more than forecast in February. And for the previous month, the figures were sharply revised downwards.

This is clearly bad news for store chains. But because most UK retailers don’t own their shops – they lease them – weak consumer spending is also a worry for their landlords.

As with industrial and warehouse space, shops are valued on what they earn for their owners. Struggling retailers may not generate enough cash flow to pay the rent. My colleague Phil Oakley gives you chapter and verse about this here: The game’s up for Game Group – but who’s next? But in short, lower returns, either through rent defaults or higher vacancy rates, will hit landlords’ property valuations.

What’s more, when shops fall vacant, they’re very hard to re-let. At the national level, over 50% of empty shops have been unoccupied for more than two years.

Don’t buy commercial property – buy this stock instead

All in all, Roger Bottle and Ed Stansfield at Capital Economics now see “tentative signs that [a] fresh downturn in all-property rents has begun”. As a result, “over the coming months, falls in capital values are likely to accelerate further”.

That’s hardly a good omen for REIT share prices. So if you’ve been tempted to dabble in the sector, it might be worth having a rethink.

But for a while we’ve been suggesting 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 RSA (LSE: RSA), the country’s largest property insurer?

RSA is cheap – it’s on a current year multiple of around 8.4, while the prospective yield is 8.6%. That level of yield implies some chance of a future dividend cut. But if you’d like a lower risk way of playing RSA that’s currently yielding almost 7%, Phil spells one out here.


David Stevenson writes for The Fleet Street Letter, Britain’s longest-running investment newsletter.

Read more about The Fleet Street Letter and David’s research here
. The Fleet Street Letter is a regulated product issued by Fleet Street Publications Ltd.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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4 Responses

  1. 27/03/2012, David Klein wrote

    Be careful of generalising about retail property. Although, according to your figure, 50% of all empty shops nationally have been vacant for more than 2 years, I doubt that there is much long term vacancy on shops in prime pitches in good towns. Timing is important in commercial investment property but location is also a key factor, especially in the retail sector, where prime pitches in top towns are usually good defensive stock.

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