Investors in commercial property should be under no illusions. Historically, commercial property’s total return has been driven overwhelmingly by income. For example, over the last 15 years, European commercial property’s net income return has averaged 5.6%, while investors have managed a capital return of just 1.2% a year.*
Many negative factors lie behind the low capital return. Two examples: attempts by corporations to cut office costs, and by retailers to cut store space in expensive urban areas, have pushed down property values by reducing demand.
On the other hand, income returns have been resilient, largely because investors have demanded higher yields to make up for the lack of capital gain.
Yields from commercial property have, moreover, been remarkably resilient during this era of low interest rates. Prime office yields across 11 major European office markets, including London, Paris and Frankfurt, have admittedly fallen to a touch below 4% from a peak of almost 6% in 2009. On the other hand, the yield gap with European government bonds is about 3% – close to a record high. The gap is similar in Japan, and slightly higher in South Korea.
Investors should, however, never be under the illusion that income can be taken for granted.
In particular, they should avoid the temptation to assume that once they have bought a property with a long lease, the income can take care of itself.
The single-minded pursuit of long leases is potentially risky.
Far from it. The single-minded pursuit of long leases is potentially risky. Consider the salutary lesson of Southern Cross, the UK nursing homes company.
The Southern Cross leases seemed too good to be true. Senior healthcare was believed to be a stable, secure property sector – almost a poster child for those arguing for the virtues of diversifying into new areas of commercial property in the search for income. Moreover, many of the leases had uplift clauses that were generous (from the point of view of the landlord).
It turned out that the leases were indeed too good to be true: Southern Cross collapsed in 2011, unable to cope with falling occupancy levels and high debts. The rental uplift clauses that had seemed so attractive in fact contributed to this fall from grace, by making the leases unaffordable – Southern Cross had fallen prey to over-renting, where the contracted rent on long-lease properties rises above the market rent. It was a classic case where long leases lulled property owners into a false sense of security. The future turned out to be deeply insecure; the leases contributed to the destruction of yield, when the landlords lost their tenant.
Another example of over-renting was V&D, once the largest department store chain in the Netherlands, which finally went bankrupt in 2015. The locations of V&D stores were no longer quite up to the mark – they were generally outside destination retail locations, which draw thousands of people hoping for a long, enjoyable and high-spending shopping experience. V&D outlets found it increasingly hard to sustain their heavy rents on their ever weaker shoulders. Just as long leases do not necessarily mean stable income, short leases do not necessarily mean unstable income. Some multi-lease industrial estates with short leases in urban areas where spare property is in short supply, such as the inner districts of London, Paris, Munich and Stockholm, can also provide durable income. Rents are high, and properties can be re-rented fairly easily.
There is also the prospect of spectacular capital gain, as in the longer term they may be redeveloped from clusters of warehouses, builders’ suppliers and the odd petrol station, to higher value uses such as high-end housing. Having said that, investors should be aware that realizing these capital gains is heavily dependent upon planning consent, successful business negotiations and the sometimes rather slow march of time when it comes to urban regeneration. If these investments don’t make sense from an income point of view, they should be avoided.
Yields in commercial property are strong and stable when the assets are high-quality
Ultimately, yields in commercial property have historically been strong and stable when the assets are high-quality, but we do not mean quality in the conventional sense, of flagship assets in famous locations with long leases and modern specifications. As the example of multi-lease industrial estates shows, what we mean is properties admirably adapted to their markets – admirably adapted in the sense that inherent demand means there is little time when they are not generating a good rental income.
The notion of what is quality in commercial property is, moreover, changing more rapidly than ever before. Many high streets in market towns that used to be thriving shopping areas are fast becoming retail deserts; at the same time, sites that used to be in the middle of nowhere are now in the middle of everywhere, as e-retailers demand large warehouses and distribution centers near major transport nodes. Another increasingly promising area is convenience retail. These include stores near stations or at well-connected retail destinations that allow people to combine their dutiful weekly food shop with a more fun foray into fashion.
Little of this offers the prospect of spectacular overnight gains. To borrow a phrase sometimes used about the stock market, commercial property should be seen as a get-rich-slow scheme, based on the steady flow of rent payments. Returns are, statistically, far less likely to come from rapid capital growth, though the odd investor can strike it lucky. They are far more likely to come from the gradual accumulation and compounding of income over the years – often from a succession of tenants for each property, rather than just one.
John Danes, Head of Continental European Property Research
*Source: MSCI, January 2017.
Property investments may carry additional risk of loss due to the nature and volatility of the underlying investments and may not be available for investment by investors unless the investor meets certain regulatory requirements. In considering the prior performance information contained herein, potential investors should bear in mind that past performance is not necessarily indicative of future results, and there can be no assurance that such investments will achieve comparable results.