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Yield Compression
Shop Investment
29/May/2013
I have resisted commenting on the Portas review of the ‘High Street’ and ensuing media and industry reports, because all of what has happened, is happening, and likely to happen I wrote about years ago in my newsletters for clients and contacts. Years ago, it wasn’t difficult, at least not for me, to predict with certainty what was bound to happen as a consequence of retailer expansion combined with a failure by directors to recognise let alone appreciate the shift in attitude amongst shoppers. In resisting also the temptation to say I told them so, there is, nevertheless, a lesson to be learned, the message of which may still not be appreciated.
A difference can exist between the value of a shop property with vacant possession and its value as an investment. Generally, in prime trading positions, the definition of which will vary depending on retailer activity, the number of propositions for sale is few and far between. One reason for scarcity is that where tenant demand for premises exceeds supply the market rent and prospects for rental growth could exceed comfortably the value with vacant possession; in short, the property has investment potential.
In secondary positions, the definition of which also varies, the investment potential is by no means as identifiable. The availability of propositions is often dependent upon incumbent owners’ reluctance to sell, or be able to afford to sell if overly indebted. Generally, private investors are tax- and loss-averse so less likely than institutional and professional landlords to rejig portfolios to synchronise with changes in retailing, and will often hang on to ex-growth, problematic, and empty premises in the hope of better times ahead.
Investment is about becoming better off than you were, but successful investment is about timing and not every shop property has investment potential . Buying a vacant property let’s say for £300,000 and letting at £30,000 pa - 10% yield (ignoring costs and tax) - means that after 10 years, you’ve your money back plus a property that, all other factors remaining constant, would fetch £300,000 but, adjusting for likely inflation, would buy less than today. Property has a reputation as a hedge against inflation, but the market is inefficient, so capital value does not have to go up, and neither does the rent. There are plenty of places where values have remained static for years, or fallen. An ‘upward only’ review to market rent during the 10 years may not help: all that means is that the rent payable after the market rent is agreed or ascertained will not be less than the rent payable before the review (unless provided for in documentation). And even if the market rent does increase, no reason to assume a commensurate increase in capital value: a rent increase might merely counteract a fall in capital value.
In the shop property market, a strong correlation exists between investment potential and tenant demand. An investor that ignores, overlooks or does not appreciate the subtle influences affecting demand does so at his peril. The landlord owns the building, not the tenant’s business. .
Often the price of a retail property investment is based on an artificial evaluation that bears little or no relationship to the underlying value of the property. Ignoring special situations, such as redevelopment, the perceived difference in value may come about from creative thinking. For example ‘yield compression, a feature of the pre-2008 boom years, is valuation by reference to interest rates. An inflated method of pricing, the downside of which is evaporation the moment the supply of cheap money dries up, as the banks have discovered in the undoing of investors that had overpaid. Could it happen again? The market is awash with cash-buyers, stock market emigrants, SIPPers, and overseas investors for whom the rate of exchange makes commercial property seem good value, mostly buying on yield.
As a rule, it makes more sense to buy at or close to the bottom of the market. However, quite apart from the opportunity being in what you actually buy, rather than just anything, most investors shy away from the bottom of the market; either they don’t have the experience to assess whether prices are rock-bottom or they get petrified by tales of doom and gloom. The bottom of the market is a paradise for the shrewd investor. The buyer that would need a mortgage before completing the purchase, let alone exchange contracts, is not in the same league.
Although timing the bottom makes sense in the context of possible uplift, it is often better to buy when prices are higher because rising prices are more likely to bring out the sellers of propositions worth buying. However, the question is why are prices higher? The answer is not necessarily an improvement in confidence; in the prevailing climate, it is pursuit of yield.
When there are ‘extra layers’ between buyer aspirations and the underlying value of the property, the buyer can be fooled into thinking the investment would at least maintain the purchase price. That would only hold true when others share the same attitude and there is enough momentum for the proposition to be re-sold for at least the same price. If you are buying to keep indefinitely and/or for a pension, momentum is risky: it is difficult to predict when the attitude might change, also how far from the end or close to the start of a momentum your timing. Waiting for others to make the first move is ‘confidence compression’ and is nothing to do with the underlying value of the property.
Underlying value is affected by the calibre of tenant demand for the premises. However, where many investors come unstuck is in equating tenant covenant with trading position. In my opinion, prevailing higher yields are not good value compared with the recent past. In my opinion, the lower yields of yesteryear were the aberration, the higher yields now the norm.
A difference can exist between the value of a shop property with vacant possession and its value as an investment. Generally, in prime trading positions, the definition of which will vary depending on retailer activity, the number of propositions for sale is few and far between. One reason for scarcity is that where tenant demand for premises exceeds supply the market rent and prospects for rental growth could exceed comfortably the value with vacant possession; in short, the property has investment potential.
In secondary positions, the definition of which also varies, the investment potential is by no means as identifiable. The availability of propositions is often dependent upon incumbent owners’ reluctance to sell, or be able to afford to sell if overly indebted. Generally, private investors are tax- and loss-averse so less likely than institutional and professional landlords to rejig portfolios to synchronise with changes in retailing, and will often hang on to ex-growth, problematic, and empty premises in the hope of better times ahead.
Investment is about becoming better off than you were, but successful investment is about timing and not every shop property has investment potential . Buying a vacant property let’s say for £300,000 and letting at £30,000 pa - 10% yield (ignoring costs and tax) - means that after 10 years, you’ve your money back plus a property that, all other factors remaining constant, would fetch £300,000 but, adjusting for likely inflation, would buy less than today. Property has a reputation as a hedge against inflation, but the market is inefficient, so capital value does not have to go up, and neither does the rent. There are plenty of places where values have remained static for years, or fallen. An ‘upward only’ review to market rent during the 10 years may not help: all that means is that the rent payable after the market rent is agreed or ascertained will not be less than the rent payable before the review (unless provided for in documentation). And even if the market rent does increase, no reason to assume a commensurate increase in capital value: a rent increase might merely counteract a fall in capital value.
In the shop property market, a strong correlation exists between investment potential and tenant demand. An investor that ignores, overlooks or does not appreciate the subtle influences affecting demand does so at his peril. The landlord owns the building, not the tenant’s business. .
Often the price of a retail property investment is based on an artificial evaluation that bears little or no relationship to the underlying value of the property. Ignoring special situations, such as redevelopment, the perceived difference in value may come about from creative thinking. For example ‘yield compression, a feature of the pre-2008 boom years, is valuation by reference to interest rates. An inflated method of pricing, the downside of which is evaporation the moment the supply of cheap money dries up, as the banks have discovered in the undoing of investors that had overpaid. Could it happen again? The market is awash with cash-buyers, stock market emigrants, SIPPers, and overseas investors for whom the rate of exchange makes commercial property seem good value, mostly buying on yield.
As a rule, it makes more sense to buy at or close to the bottom of the market. However, quite apart from the opportunity being in what you actually buy, rather than just anything, most investors shy away from the bottom of the market; either they don’t have the experience to assess whether prices are rock-bottom or they get petrified by tales of doom and gloom. The bottom of the market is a paradise for the shrewd investor. The buyer that would need a mortgage before completing the purchase, let alone exchange contracts, is not in the same league.
Although timing the bottom makes sense in the context of possible uplift, it is often better to buy when prices are higher because rising prices are more likely to bring out the sellers of propositions worth buying. However, the question is why are prices higher? The answer is not necessarily an improvement in confidence; in the prevailing climate, it is pursuit of yield.
When there are ‘extra layers’ between buyer aspirations and the underlying value of the property, the buyer can be fooled into thinking the investment would at least maintain the purchase price. That would only hold true when others share the same attitude and there is enough momentum for the proposition to be re-sold for at least the same price. If you are buying to keep indefinitely and/or for a pension, momentum is risky: it is difficult to predict when the attitude might change, also how far from the end or close to the start of a momentum your timing. Waiting for others to make the first move is ‘confidence compression’ and is nothing to do with the underlying value of the property.
Underlying value is affected by the calibre of tenant demand for the premises. However, where many investors come unstuck is in equating tenant covenant with trading position. In my opinion, prevailing higher yields are not good value compared with the recent past. In my opinion, the lower yields of yesteryear were the aberration, the higher yields now the norm.