Whatever happens to economic growth, 2014 should be a good year for global property, with high single-digit returns in prospect for selective investors. US large cap property stocks should be set for a come-back. In a relatively strong Far Eastern market, Hong Kong and Singapore look particularly undervalued.
2014 should be a capital value story
The big unknown in 2014 is whether an economic recovery globally continues to gain traction, particularly in the US, China and Europe. Either way, we believe that property looks well placed. Even if economic growth proves disappointing, the absence of new supply coming onto the market will be good news for property values, given the strength of investor demand. And if the global economy takes off, investors should also benefit from rental growth.
At this stage, the most realistic prospect is for growth to pick up in the second half and start to be reflected in property share prices in the early part of the year. The challenge for property investors in 2014 will be to differentiate between those companies whose valuation fully discounts the outlook and those where there is further value to be unlocked. But the sector as a whole could benefit if inflationary pressures start to appear, as we expect property would be sought after as a hedge, particularly for those investors with big fixed income holdings.
We believe Asia will lead the way in 2014, with total returns of 12%-15%, including dividend yields of 2%-3%.
We think the US will be close behind, with total returns of 8%-10% overall - and even more for large-capitalisation REITs (real estate investment trusts) - including a dividend yield of perhaps 3%. Meanwhile, even without any capital growth, Australian yields of 6% will look enticing, even with a low level of economic growth, and a relatively dull Europe could generate 7%, including a yield of about 4%.
US: large caps set to make a come-back
2014 should see the resolution of one of the biggest questions facing US property investors: when will the undervaluation of the sector's large-capitalisation companies start to reverse? We expect this anomaly to diminish once the Federal Reserve finally starts the process of 'tapering' its asset purchasing programme.
Tapering will almost certainly be accompanied by signs of further economic strength and at least the expectation of interest rate rises. These are circumstances which should favour large caps over their generally highly-leveraged and more interest rate sensitive small-cap brethren, sparking renewed interest from investors.
The change in mood may coincide with a general reappraisal of REIT valuations, which have suffered lately. Passive funds and more generalist investors are likely to use the sector as a way to ride the economy if growth picks up. So, while the exact timing remains uncertain, we expect sentiment in US property to start to improve next year, particularly in large cap stocks.
Hong Kong and Singapore look good value
We believe the Hong Kong market is one of the cheapest anywhere right now. There has been a cooling at the top end of the residential market since the government raised stamp duty rates and tightened marketing requirements. However, there remains plenty of demand for mid-priced and cheaper housing in a market where there is virtually no new property coming onto the market. Were it to revert to the mean, we believe Hong Kong could return as much as 15%.
Singapore is another market we think has good prospects. It was unfairly hit during the sell-off in emerging markets earlier this year as investors anticipated problems that haven't materialised. With discounts to net asset value of up to 40% - well over double the historical average - we anticipate healthy returns as discounts revert to the mean (assuming the government does not implement any significant measures to slow the property market).
China and Australia offer contrasting outlooks
China remains a crucial element in the property story for 2014. If, as we expect, economic growth is sustained, this will provide a fillip, not only for other Asian property markets, but for those of the rest of the world too. However, having been surprisingly strong in 2013, its own property market may moderate next year.
The picture looks different in Australia. Despite continuing weak economic data, housing surveys suggest that the residential market is starting to strengthen again. Property certainly now looks fairly valued from an investor's perspective, while dividend yields of around 6% are very attractive compared with an official interest rate of 2.5%. That gap may widen even further if the Reserve Bank of Australia moves to cut rates to deal with an overvalued Australian dollar.
Caution needed in Japan
The slowing economy is prompting caution amongst Japanese landlords. They are putting a higher priority on maintaining and increasing occupancy than on raising rents right now. Elsewhere, we believe the focus for investors will shift from real estate investment trusts (J-REITs), which have been a target of the government's asset purchase programme, to other parts of the property market, notably development companies. We think investors will need to remain selective in Japan, with further progress in the property market very much dependent on the success of Prime Minister Shinzo Abe's economic stimulus programme.
Europe
The UK property market is likely to remain strong but, after a good run, investors will need to be selective about which companies they bet on in 2014. France also contains pockets of value. While retail continues to struggle there generally, a number of flagship shopping centres continue to benefit from healthy numbers of shoppers. Other parts of Europe look less exciting. The Nordic countries are unlikely, we think, to reverse recent falls in rents and capital values, while investment choice will continue to be limited in Germany.
Duncan Owen gives his views on what's in store for UK commercial property in 2014:
A quick virtual tour of the UK on Google Earth would show a commercial property market in increasingly good shape. Stronger economic growth is starting to lift tenant demand; rents and capital values on average are broadly stable; new building is at a low point in the cycle and there is still a generous gap of 325-350 basis points between the IPD UK Monthly Index All Property initial yield at 6.25% and the 10 year UK gilt yield (currently 2.84%*).
In addition, the entry of new lenders such as insurers and debt funds and the re-entry of re-capitalised banks, has led to a significant improvement in the availability of debt.
Regional variations
Although the big picture is positive, there are still large variations in investment returns across different locations and types of commercial property. Thus, while the recovery in demand for office and industrial space which began in London in 2010 is now spreading across the UK, some regional towns and cities still have high levels of vacancy following the recession. Accordingly, whereas prime office rents in the West End of London rose by 8% over the 12 months to September 2013, prime office rents in Birmingham, Manchester and Glasgow were flat over the same period.
Likewise, retail property continues to suffer from the switch to online shopping. Verdict Research estimates that the internet now accounts for over 40% of electrical and electronic goods sales and its share of clothing and footwear, which is a mainstay of many shopping centres, has jumped to 14%. As a result, the retail property market has become extremely polarised; while certain big shopping centres, retail parks and city centres continue to attract shoppers and trade well, many ordinary high streets are in long-term decline.
So where do we see investment opportunities in UK commercial property? Below are five ideas. The first three seek to capture structural change which is changing the demand for commercial property, independent of the economic cycle, while the final two ideas look to exploit mispricing in the investment market.
Investing in structural change
First, investing in new, or modern offices in cheaper areas of central London with good public transport (e.g. Farringdon, King's Cross, Waterloo). Large companies are increasingly reluctant to pay for a prestigious address in Mayfair, or the City of London, and by moving to a new headquarters in a cheaper location they often not only save on their rent, but also get the opportunity to accommodate all their staff under one roof and cut their carbon emissions, compared with their old offices.
Second, the growth of online retail sales is re-engineering the logistics industry and we see growing demand for smaller warehouses around London and other large cities, which can be used as express parcel hubs and for next day, or even same day, deliveries.
Third, the rapid growth in the number of frail elderly people is increasing the demand for extra care and nursing homes. Despite the failure of Southern Cross in 2011, we still believe that nursing homes can provide attractive returns, if rents are set at levels which operators can afford.
Mispriced opportunities
Fourth, while vigorous demand from foreign investors has driven yields on prime properties back down to pre-crisis levels, we still see value in offices and industrials with good "bricks and mortar" fundamentals, but which have short leases, or are multi-let. The recent upturn in house prices has also increased the potential gains from re-developing old offices and industrial units.
Fifth, despite all the structural challenges facing retail property, we are starting to see a few interesting opportunities, as other investors shun the sector. In particular, we see value in some modern retail schemes in prosperous market towns, which provide retailers with efficient and affordable space.
Guarding against downside risks
In conclusion, our central strategy is to invest in properties delivering an income return of 5.5% to 7.5% and which are benefiting from structural change. That should provide some protection if economic growth falls short of expectations, delaying the recovery in rents. The other downside risk, which is harder to manage, is what would happen to property yields if there was a sharp increase in long-dated gilt yields, perhaps in response to a jump in US bond yields.
A lot would then depend upon where we are in the rental cycle. If rents are rising, then investors might ignore the increase in long gilt yields, as happened in 1999. However, if rents are static and there is little immediate prospect of growth, then a jump in long gilt yields would probably feed through to property yields, depressing capital values.
