There's safety in stable foundations

There's safety in stable foundations

By Patrick Sumner - Feb 21, 2007
The Business Times

AFTER months of expectation, real estate investment trusts (Reits) are finally here. So far, nine major property companies have announced their intention to convert to the new structure, and we expect another nine to throw their collective hats into the ring by the middle of the year.

Investors were quick to spot this potential opportunity to make early gains before the announcements to convert were made. As a result, UK property stocks were up around 10 per cent in December last year.

But just over a week after the UK Reits launch, Land Securities, British Land and Hammerson, all of which were among the first nine companies to adopt the UK Reits structure, fell sharply as investors took profits.

So should investors be concerned that the case for investing in property funds is built on shaky foundations? Not while the fundamentals remain unchanged.

Property equities are prone to occasional bouts of short-term weakness, but when general investors collect profits and move out, the long-term institutional investors are keen to step in to take their place. With future forecasts anticipating no further fall in yields, it is not unreasonable to expect growth of 12-15 per cent in 2007.

Despite the recent short-term sell-off, demand for property investment from pension funds, insurance companies and private investors is still very healthy. That is a solid driver that isn't going to change in the short term. Property equities are recognised as a safe, long-term asset class offering diversification benefits and displaying both equity and bond characteristics. For these reasons property will remain popular with investors of a maturing risk/return profile that are searching for yield.

Commercial concerns

Demand for commercial property within Europe and the UK is still outstripping supply and, importantly, portfolio quality within the major property companies remains very high. They hold good quality office space (especially within central London) and are continuing to benefit from high employment levels and strong rental growth. The retail sector offers very consistent, positive rental growth from tenants, especially at the prime end of the shopping centre market.

We are starting to see increased allocation from US institutions keen to seek returns in excess of those that can be achieved domestically, but under a recognisable investment structure such as Reits.

A further positive indicator is the example of Australia, where currently 9 per cent of every worker's payroll goes directly into pensions. Of this a significant amount finds its way into real estate. The UK and Europe still has a long way to go before property investment reaches those levels.

It would be a mistake to confuse residential markets with commercial markets. Clearly 12 square metre apartments in London and broom cupboards in Chelsea selling for silly prices do attract 'bubble' headlines, but commercial property is not synchronised with residential property and property shares have very little exposure globally to the housing market.

While consumer debt does remain a concern, especially in the UK, where the fear of rising interest rates is unsettling borrowers, within commercial property, rising interest rates are not necessarily a bad thing.

Assuming that interest rates rise in response to higher inflation and stronger economic growth, commercial property income will also rise. There is also a strong correlation within the UK and Europe between rental growth and inflation. So again, commercial property investment is a valuable hedge against interest rate and inflation rises.

With such large inflows into property equity companies over the past couple of years, the concern must be whether there is enough capacity within the larger companies to keep absorbing this money. Without any new issuance coming to market, there is a danger of prices pushing up beyond fair value. Small corrections such as the one experience in January are therefore quite welcome, as another year of returns of more than 20 per cent would lead us to rethink the positioning of our portfolio in anticipation of a nastier correction to come.

Investors will do well to ignore the 40 per cent-plus headline-grabbing returns of the last three years and remember that property equities are a very useful diversifier, offering low volatility and long-term stable growth. Investors should also be looking for geographical diversification, to take advantage of the various economic cycles.

We won't see the returns that we have seen over the past two to three years, but a period of lower double-digit returns in 2007 would be no bad thing, and it certainly doesn't undermine the long-term case for investing in property equities as part of a diversified investment portfolio.

The writer is head of property equities at Henderson Global Investors.