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Income Appeal of Commercial Real Estate Investment

June 28

I recently read an article in the June 22nd issue of The Economist.  The story articulates the benefits of commercial real estate investment as compared to other income investment vehicles and the reasons why.  The article is included below:


Building the next boom

Commercial property may benefit from its income appeal

During the debt crisis of 2007 and 2008 commercial-property investors lost around half their capital. That slump reminded investors that the asset class is anything but a one-way bet. Lost ground has been regained, particularly in prime locations, although there is still nothing like the buzz around commercial property that there is around equities, with the Dow Jones Industrial Average hitting new highs and the Tokyo stockmarket surging by 77% before its recent fall.

But perhaps property is about to have another moment in the sun, thanks to its income appeal. Cash yields next to nothing and despite talk of “tapering”, central banks show no sign of raising short-term rates. The search for income has driven ten-year government-bond yields down to 2% or so; high-yield bonds belie their name by offering only 5%. Commercial property offers a decent income stream to yield-hungry investors plus the potential for some protection against inflation, something conventional bonds do not.

One reason why property may do well in a low-rate environment is the relationship between rental yields and the property investor’s cost of finance. If rental yields are high then investors or speculators will find it easier to cover their financing costs, and the potential for capital gains is the icing on top. (This is a rough-and-ready measure: landlords must pay maintenance costs and, in weak economies, may face a shortage of tenants and thus a high level of vacancies.)

Investment Property Databank (IPD) has figures for British property returns and rental yields dating back to December 1987. So The Economist compared the rental yield with base rates (as a proxy for the cost of finance) in every month over the past quarter-century, and then looked at the total return from property over the subsequent 12 months. The data were sorted into quartiles (see chart).

Sure enough, when the gap between rental yields and base rates was positive and high, subsequent property returns averaged 12.4%. When the gap between rental yields and base rates was negative, the average return was just 2.7%.

Rental-yield data for other markets are less reliable than for Britain because property values are not always marked to market. Despite these limitations IPD figures show yields ranging from 5% to 7% in developed markets, well above the level of interest rates in most countries.

There are some important caveats. First, property is very illiquid, unlike a bond or a share that can be bought and sold in minutes. Second, there are significant transaction costs. For retail investors looking to get diversified exposure to the commercial-property market, the easiest option is to buy exchange-traded funds (ETFs) based on the various property indices. But the effect of investing at one remove is to dilute the asset’s income appeal: the Asia index offers a yield of 3.5%, Europe 4.3% and America 2.7%.

Third, the relationship between low rates and property returns may have broken down in the current cycle. Banks are less willing to provide finance to landlords than they were during the credit boom. A prolonged period of sluggish economic growth means that it is difficult to find good tenants, particularly in the retail sector, which is facing the long-term challenge of internet shopping. The IPD numbers show very little rental growth over the past two years—a cumulative 1% or so in Britain, France and Germany.

A survey by CBRE, a property-services group, found that global office-occupancy costs (which include property taxes as well as rent) increased by just 1.4% in the year to end-March 2013. Nevertheless, the numbers do hint at where the bright spots in the global economy may be. Six of the ten markets with the fastest-rising costs are in North America, and the other four are located in Asia. Mumbai is as expensive an office market as Paris; costs in Ho Chi Minh City in Vietnam are almost as high as in Frankfurt.

So property investors may need to be selective. But the global economy faces four potential outcomes: a return to healthy growth (in which case rents should rise); a low-growth, low-inflation period in the doldrums (in which case the income appeal of property should help); a return of rapid inflation (as a real asset, property should offer some protection); or a deflationary slump. Only in the last case would property suffer. Three-out-of-four seems like good odds.