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The real state of real estate

Created:

11 November 2009

Updated:

16 November 2009

Written by:

Algy Hall

In 1975 an economist called Charles Goodhart came up with a theory that statistical relationships in the economy break down when they become a target for economic policy. Goodhart's Law, as the theory has become known, often looks equally applicable to the investment world as it does to the real economy, and the real-estate sector currently looks a case in point.

Cast your mind back a few years, and you may remember the hype that made commercial property such a hot investment. Real estate's allure was that over the years it had been much less volatile than equities and allowed investors to diversify risk, because it only had a modest link with stock market performance. Based on the statistics, it made a convincing story. While the dot-com fall out caused the FTSE 100 to plummet 53 per cent from the start of the millennium to March 2003, the IPD All Property index saw a 5.5 per cent increase in capital values and produced a 33 per cent total return.

A break with the past

However, the plight of commercial property has broadly mirrored that of equities since markets went into free fall mid-way through 2007. The IPD All Property index has recorded a 44 per cent fall in capital value from its peak at the end of June 2007 to its trough at the end of July 2009.

Due to the illiquidity of property, the index is only compiled once a month and by its nature will not be as extreme in its highs and lows as equity indices. Nevertheless, while the IPD index decline was smoother than the fall in equities, it came pretty close to the 49 per cent fall racked up by the FTSE All-Share from its June high to March low and the 48 per cent decline from blue chips over the same period. On a total return basis, IPD showed a 36 per cent peak to trough loss compared with a 41 per cent decline in an equivalent investment in the FTSE All-Share.

Anecdotal evidence suggests commercial property has also been recapturing lost ground with similar gusto to equities. While this is yet to really show up in the monthly IPD data, property investors are talking of 25 per cent price rises in the high-quality end of the market based on recent deal values.

So, rather than offering investors diversity from equities and lower volatility, it looks like real estate is now simply delivering more of the same. The expectation of prices rising at breakneck speed is reflected in the performance of the shares in big UK Reits since they hit their 2009 lows (see table).

Bubble hopping

But why should such a long-term statistical trend break down? Ironically a key issue, as Goodhart's Law would suggest, has been the sheer weight of money targeting historic real-estate-style returns. According to property consultancy DTZ, UK commercial property transactions averaged a massive £48bn a year between 2004 and 2007, which compares with an average of £30bn a year in the three preceding years, £23bn in 2008 and just £14bn in the first three quarters of 2009.

It seems like a different type of property bubble driven by lack of supply rather than excess demand may now be the cause of an equity-style bounce. Thanks to government support, banks seem increasingly willing to ride out the downturn by allowing bad loans to run, as long as interest is being paid. This means overstretched borrowers don't have to sell properties and provide the catharsis to the crash that would otherwise be expected to provide the foundations for the return to normality.

Instead there is a hiatus in supply at the same time as increasing demand. This is pushing up prices fast, which could itself encourage more demand as investors scramble not to miss the boat. Would-be property buyers include large unit trusts that are receiving inflows from private investors still beholden to commercial property's allure (see What's the best way to buy into property?, 21 Oct), a plethora of vulture funds that have raised money to buy from distressed sellers of which there are very few (see Banks limber up for property workout, 14 Nov), and foreign buyers flush with cash and tempted by the weak pound. But even though property prices are rising, the rental income which plays an important determinant in commercial property values is falling (see The Reit time to take profits?, 27 Oct).

For the time being, buyers of commercial property look like they'd do well to remember that familiar bit of Financial Services Authority (FSA) small print: past performance is not a guide to future performance.

Fall from 2007 peak to 2009 trough

Rise from 2009 trough to peak

Source: Thomson Reuters Datastream