August 29 For professional investors and advisors only. Not suitable for retail clients. Schroders Investing in Property During and After a Recession Mark Callender Head of Property Research, Schroders The last few months have seen a definite improvement in the performance of UK property. Whereas in January and February 29 property total returns were running at -2.5% per month, in May the one month total return improved to -.9% and in July total returns turned positive at.6% (source: IPD Monthly Index). This promising trend begs the question is now the right time to re-enter the UK property market? Figure 1 Monthly property performance Total returns turn positive in July Percent per month 1-1 -2-3 -4-5 -6-7 Jun- 27 Aug- 27 Oct- 27 Dec- 27 Feb- Apr- Jun- Aug- Oct- Dec- Feb- 29 Apr- 29 Total returns Capital growth Rental growth Yield impact Jun- 29 Source: Investment Property Databank (IPD) Monthly Index, July 29 The obvious reason for being cautious is the negative impact which the recession is having on tenant demand and open market rental values. Initially, open market rental values held up quite well and last year saw only a modest fall of 1.4% (source: IPD). However, this year has seen a sharp deterioration, as insolvencies have increased, companies have opted not to renew leases on expiry and some tenants have attempted to sub-let surplus space. In addition, cuts in the relief from rates on empty buildings has put pressure on landlords to drop rents on new leases in order to attract occupiers. Open market rental values fell by 6% in the first half of 29 and while the rate of decline has slowed slightly in recent months, it is possible that the next few quarters could see a further deterioration as vacancy rates increase. 1
Yet, despite the weak outlook for open market rental values, we believe that now is a good time to review allocations to UK property. First, although open market rental values are likely to continue falling through the second half of this year and into 21, the income on existing leases is protected by the upward only rent review clause. The rental income on portfolios only fell by 1% in the first half of 29 (source: IPD). Second, the unprecedented gap between the all property initial yield at 7.8% in July and long gilt yields at 3.75% and cash at below 1% suggests that a lot of the bad news on the occupier market is already in the price. The second quarter saw a limited pick up in demand from private and overseas investors, primarily for quasi bond-type properties let to strong tenants on long leases. It is this partial revival in investor demand which explains the more gradual increase in valuation yields since May (shown as a less negative yield impact in Figure 1) and the parallel improvement in total returns. Figure 2 UK property market update: forecast returns Total returns and components Percent 3 2 Forecast 1-1 -2-3 -4 26 27 29 21 211 212 213 Income return Rental value growth Yield impact Total return Source: IPD, PMA, Schroders, August 29 Please refer to the Important Information regarding forecasts. One way to try to settle the debate is to reference the latest property forecasts. The derivatives market is currently pricing in an all property total return of -6% in 29, 8% in 21 and 11% in 211 (source: RBS). Schroders own forecasts show a similar upward trajectory. Given that all property total returns in the first half of 29 were -9.6%, the consensus in the derivatives market is that there won t be a major double-dip in returns later this year, in spite of the fall in open market rental values. Looking further forward, the derivatives market seems to be assuming that investor sentiment towards property will continue to strengthen and that property yields will fall in either 21, or 211. In short, the forecasts suggest that now probably is the time to consider re-entering the UK property market. Of course property forecasts are only as accurate as the assumptions on economic growth which underpin them. Reassuringly, the consensus view on the UK economy has not changed materially in the last few months and current forecasts suggest that GDP will fall by 4% in 29 and then increase by 1% in 21. However, there remains an outside possibility that the recession will intensify in the second half of this year, or in 21 and that the fall in open market rental values will be even steeper than anticipated. Another approach to tackling the issue is to analyse the returns which have been achieved by investors who invested in property during previous recessions. In the USA research published by the National Council of Real Estate Investment Fiduciaries (NCREIF) and Townsend Group has shown that closed ended property funds launched in 21, the last recession in the USA, have outperformed both earlier and later vintages. 2
Figure 3 US opportunity funds Median net IRR between inception and first quarter 29 Percent 3 25 Recession 2 15 1 5 1997 1998 1999 2 21 22 23 24 Source: NCREIF, Townsend Group, July 29 Unfortunately, there is no corresponding analysis for UK funds, but it is possible to use the IPD Monthly Index to see how the property market performed on an ungeared basis through the last UK recession of the early 199s. That recession began in the third quarter of 199 and ended in the second quarter of 1992. Figure 4 shows the performance of property before, during and after the recession in real terms, adjusted for inflation. Figure 4 Property in the early 199s recession Performance in real terms Percent per year Recession 2 1-1 -2 1988q1 1989q1 199q1 1991q1 1992q1 1993q1 1994q1 Total returns Income return Open market rental growth Yield impact Source: IPD Monthly Index, July 29 Total returns peaked in late 1988, eighteen months ahead of the recession and then progressively lost momentum through 1989, as rental growth slowed and as property yields rose, reflecting increasing nervousness among investors about the economy. (The rise in yields is shown as a negative impact). The onset of the recession in mid 199 added further impetus to the increase in yields and rental values began to fall in real terms. Capital values fell by 21% in 199 in real terms and real returns reached their nadir in the first quarter of 1991 at -14.9%. 3
The second year of the recession from mid-1991 to mid-1992 saw a clear improvement in property returns. Although the collapse in rental values accelerated, the increase in property yields moderated, as the investment market found a new equilibrium. In addition, property s performance was flattered by an increase in the rate of income return, as capital values fell, but rental incomes held steady. The initial economic recovery in late 1992 and early 1993 had no immediate impact on open market rental values. In part this was because the economy was in a phase of jobless growth and although GDP was increasing, unemployment continued to rise. In part, it may also have been because there was still quite a lot of new space entering the market, as buildings which had been started in the late 198s boom were completed. By contrast, the second half of 1993 saw a major upturn in performance and total returns peaked at 22.8% in real terms in the second quarter of 1994. Although open market rental values continued to fall, the rate of decline slowed and the all property equivalent yield fell by 15 basis points between June 1993 and June 1994, as the economy gathered pace and investors started to anticipate the next upswing in rents. Figure 5 Performance over five year rolling periods Performance in real terms Percent per year 1 Recession 8 6 4 Long term average 4.2% per year 2 4-2 1987q1 1988q1 1989q1 199q1 1991q1 1992q1 1993q1 1994q1 Source: IPD Monthly Index, July 29 Explanatory note: Total returns averaged 3.7% per year between 1987 q1 1992 q1 in real terms. First year of investment Figure 5 uses the IPD Monthly Index to calculate the ungeared real returns which investors would have received, if they had invested at different points in the late 198s and early 199s, assuming a five year holding period. For example, an investor who invested in the first quarter of 1987 and sold in the first quarter of 1992 should have received annualised real returns of 3.7% per year, assuming their portfolio tracked the index. (Please note that the IPD Monthly Index is based on standing investment properties and while it takes into account property management costs, it excludes trading costs and other fund management fees). Given the benefit of hindsight it is obvious that the best time to invest in property was just as the recession ended in late 1992, or early 1993, before investor sentiment turned positive and property yields fell. Investors who bought in the second quarter of 1993 should have received ungeared total returns of 9.3% on average over the five years to the second quarter of 1998 in real terms. However, what the chart also reveals is that investing in the second year of the recession in late 1991 and early 1992 was also favourable and that investors who invested then should have achieved ungeared real returns of 5.5-6% per year over the next five years, above the long term real average for property of 4.2% per year. Although investors who bought into the market in late 1991 suffered from the decline in open market rental values through 1992-1994, they did catch the fall in
yields in 1993-1994 and they also had the benefit of a very high rate of income return, averaging 8.7% per year. Clearly, it is tempting to draw parallels between the recent improvement in property performance and the second year of the early 199s recession. However, we should be careful not to assume that the current downswing and forecast recovery in the UK property market will be an exact repeat. On the downside, the current fall in GDP has been sharper than that of the early 199s and the future recovery will be marked by an increase in short term interest rates, rather than a fall. In addition, shorter leases mean that the rental income on property portfolios will be less robust through this recession and Schroders expects them to fall on average by 7-1% between end- and end-21. Arguably, the supply of bank debt to the commercial property market is also tighter in this recession, although the fall in property yields through 1993-1994 occurred at a point when the banks were shrinking their loan books (source: Bank of England). On the upside, this recession was not preceded by a building boom like that of the late 198s, so rents have not been hit by the same double whammy of falling demand and increasing new supply. Furthermore, the relative pricing of property is far more attractive now than at the end of 1992, when the gap between the all property initial yield (9.%) and the yield on long gilts (8.25%) was 75 basis points. Finally, the other conclusion which is self-evident from Figure 5 is that investing at the top of the economic cycle (e.g. 1988, 1989) can be disastrous. However, the problem with this simple truth is that spotting when the economy is going to falter is not easy. Paul Samuelson famously remarked that the stockmarket had forecast nine of the last five recessions and investors who entered the property market in 1988 would have initially enjoyed impressive returns. Are there any warning signs that property investors should watch? Figure 6 UK actual and potential output Output gap indicates amount of spare capacity GDP 1971 q1 = 1 Output gap % 26 8 24 6 22 4 2 2 18 16-2 14-4 12-6 1-8 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 21 23 25 27 29 Output gap GDP Potential GDP Source: Datastream, OECD, July 29 One possible candidate is the output gap which measures the degree of spare capacity in the economy. In economic theory the output gap is the estimated difference between total demand in the economy (GDP) and its productive potential, given the size and flexibility of the labour force, the stock of capital equipment and IT, education, etc. Central banks believe the output gap is important because when it is negative and there is a lot of spare capacity (e.g. high unemployment) then inflation should be low, or at least decelerating. Conversely, when the output gap is positive and the economy is operating at full capacity, then there is a danger that inflation will accelerate. The OECD estimates that by the second quarter of 29 the UK s output gap was heavily negative, indicating a large amount of spare capacity. 5
Figure 7 Invest when there is not a positive output gap? Average real returns over five year rolling periods Strongest since 1971 Weakest since 1971 1984-1989 21-26 1983-1988 2-25 1995-2 1996-21 1992-1997 22-27 1999-24 1994-1999 1997-22 1998-23 1993-1998 1976-1981 1982-1987 1985-199 1975-198 -6-4 -2 2 4 6 8 1 12 Percent return 1991-1996 1977-1982 1986-1991 1981-1986 1974-1979 199-1995 1978-1983 198-1985 1979-1984 23-1987-1992 1989-1994 1988-1993 197-1975 1971-1976 1972-1977 1973-1978 -6-4 -2 2 4 6 8 1 12 Percent return Negative output gap <-1 Positive output gap >1 Gap between -1 and 1 Source: IPD Annual Index 197. Explanatory note: The average total return between end-1984 and end-1989 was 11.7% per year in real terms. Figure 7 ranks the ungeared real total returns over 34 different five year periods, based upon the IPD Annual Index. The best performing period was end-1984 end-1989 (annualised real returns of 11.7% per year) and the weakest period was end-1973 end-1978 (annualised real returns of -4.8% per year). The five year periods have been divided into roughly three equal groups, according to the size of the output gap at the start of the period: periods when the economy was operating at full capacity at the start and the output gap was above 1; periods when the economy was in equilibrium at the start and the output gap was between 1 and -1 and periods when there was a lot of spare capacity in the economy at the start and the output gap was below -1. Although not infallible, the analysis does suggest that the output gap could be a useful indicator and that a good rule of thumb for property investors would be to avoid committing more capital and consider selling, when the economy is operating at full tilt and the output gap is above one. Looking at the nine periods when the output gap was above one at the start, there was only one period (end- 1977 end-1982) when real returns over the next five years exceeded the long term average of 4.2% per year (1971 ). The underlying rationale appears to be that if the economy is running at full capacity (e.g. end-1972, end-1987) then either inflation will take off and interest rates will have to be raised, or there is a financial bubble which sooner, or later will burst. While we do not yet have complete data for the five year periods from end-24 onwards, the output gap would have indicated in the second quarter of 26 that investors should stop adding to their property portfolios and consider selling. Turning the argument on its head, investing in property when there is a lot of spare capacity in the economy has generally proved to be a good strategy, although intriguingly it is no more successful than investing when the economy is in equilibrium. Thus investing when there was a large negative output gap in the economy at the start of the five year period achieved above average real returns on 8 out of 12 occasions. The corresponding figure for periods when the economy was in equilibrium at the start was 1 out of 15 occasions. 6
Important Information: The views and opinions contained herein are those of Schroder Property Investment Management Limited. For professional investors and advisors only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Property Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. Issued by Schroder Property Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 118824 England. Authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored. 7