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Finding opportunity in real estate

Investment in the property market may seem like an unwise suggestion in the current economic climate, but now is the time to take advantage of the forced-to-sell market. For the long-term investor with a varied portfolio, property can still provide high returns.

House prices have been falling for some time - since the middle of 2006 in the US, and the autumn of 2007 in the UK. US prices are now some 34% below their peak whilst UK prices are around 20% below their high. Other western countries, such as Spain and Ireland, have also seen price falls, though not always of the same magnitude.

More recently there have been some signs, in the UK at least, that prices have stopped falling, although this does not yet appear to be the case in the US. Interestingly, on both sides of the Atlantic, house prices now appear to be below their long term trend values (although the computation of these statistics is riddled with uncertainties). Given current economic uncertainties it is too early to become overly optimistic about the outlook for house prices, but the worst is behind us.

The outlook may be even better for commercial property prices. Again, in the UK - for which good data exists - prices, as measured by the headline IPD index, have fallen over 40% from their peak in June 2007. As a consequence, property rental yields are now, on average, over 7.5%, a significant premium to government bond yields of sub 4%, whereas in 2007 the reverse applied. 

In fact the rental yield premium over gilts, at nearly 4.0%, is higher than it was in the last property recession, although this has more to do with the fall in gilt yields than the rise in rental yields, which are still 1.5% lower than they were in 1993. 

This fall in values and rise in yields not only reflects concerns about tenants defaulting and voids rising (as a result of corporate bankruptcies such as Woolworths) but also forced sellers in the market trying to raise money to reduce their debt. The need to reduce debt and strengthen balance sheets has also caused a number of quoted property companies, such as Land Securities and British Land, to announce large rights issues. The weak economic background, particularly on the "high street", combined with forced sellers and rising defaults, will keep property valuations under pressure for some time.

Nevertheless, the current rental yields on property suggest that, depression aside (which we do not expect but which obviously remains a possibility), commercial property is becoming a cheap asset class. History suggests that values will struggle to show much, if any, progress in the near term. But for the more entrepreneurial investor, the existence of "forced sellers" has created an interesting investment opportunity. Unlike forced sellers in equity markets, who can sell a percentage of each holding, this option is not available to property owners – they either have to sell an entire property or none at all.

Thus, it has become possible to buy individual or small portfolios of properties with reasonable rental covenants from such sellers on yields of upwards of 9%. This has led to some takeover approaches in the quoted sector, such as Segro for Brixton, and the emergence of "vulture" funds which have raised money from investors to take advantage of these sellers. 

Clearly there are still considerable uncertainties in the property world but we think that for high net worth investors who can adequately diversify their portfolios, purchases of direct property from forced sellers are now an attractive proposition. For patient longer-term institutional investors with no liquidity constraints, now is also the time to consider increasing their exposure to the UK commercial property market, but they will probably have to wait longer to witness high returns.

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