Are commercial property markets being pushed to new extremes?
The number of initial public offerings (IPOs) for property investment companies skyrocketed in 2017 as investors continued to clamour for steady sources of decent income.
To meet this persistent demand, issuers have been working hard to differentiate themselves. But we are concerned that this demand and the premiums it has created may be unsustainable (figure 5).
After a turbulent 2016, many established commercial-property focused real estate investment trusts (REITs) are trading at premiums despite an uncertain outlook. High-street retail faces significant challenges and office demand across the UK is variable, while relentless demand for industrial space has pushed up prices. Fund managers are viewing this as an interesting time to launch new vehicles.
Most property IPOs in 2017 ticked multiple boxes for investors. The potential benefits include attractive yields that are uncorrelated with equities and bonds, as well as inflation-beating returns. Is this level of issuance sustainable?
Specialist offerings in some sectors are providing investors with exposure to areas for the first time, such as build-to-rent residential property. The appeal comes as much from the income source as from the new drivers of supply and demand, such as social housing projects linked to housing associations and state benefits.
While bond yields remain depressed, the appetite for alternative sources of income is unlikely to disappear any time soon. Risk of defaults on payments associated with property funds is higher than for government bonds. Yet these new trusts may offer attractive yields relative to higher credit-quality corporate bonds and inflation-linked government bonds.
IPOs and private placements also give investors the opportunity to get into funds at the net asset value (NAV), or below the market price (which can move above or below the NAV). Over the past couple of years prices have maintained a premium over NAVs. But can investors now expect this to last?
Firgure 5: UK commercial property
The graphy shows the premium and discount levels of three categories of property investment trusts in the UK
Source: Numis Securities Research
A fine balance?
In a typical multi-asset portfolio, the allocation to property is less than 5% so there may be a limit to the demand for these investments. It is also interesting to note that of the 326 funds launched between 2000 and 2009, fewer than a quarter have survived. Many funds were caught out with unsustainable levels of debt during this period.
Investors looking to new REITs as a potential source of income should be aware of the risks, which include political and regulatory changes. For example, new immigration rules could affect demand for student accommodation, and any changes to state benefits could impact the social housing sector.
Although not a great concern in the short term, the residual value of property assets should be considered. For example, will the tenants or asset operators want to rent the property at the next lease break? If not, is the property desirable enough to lease to a new tenant? Can the property be redeveloped easily for other uses?
Although participating in an IPO can ensure investing at NAV levels, it is worth bearing in mind that today’s premiums reflect the relative attraction of the income streams over other sources. If gilt yields begin to rise, the attraction of the extra yield from property investments could fall.