"This is the result of a marked divergence in the performance of commercial property since the bottom of the cycle in 2009, based on preferences for location, asset size and income quality. The scale and severity of this bifurcation has surprised some investors. However, the changing landscape of flows, yields and innovation also presents attractive opportunities for longer-term investors.
"Let us first consider the polarisation of real estate performance. For example, best quality shopping centres in the UK have increased in value by 22% in the last three years, while poorer centres have experienced a fall of 10%.
"Similarly in the US smaller neighbourhood centres have been declining in value since 2008, while super regional malls returned on average 15% in 2012 – indeed, top decile retail delivered returns of 30%. This trend of diverging fortunes is equally noticeable in global office markets where investor demand has forged a strong recovery in prices across key international core locations such as Paris, London, New York and Munich. In contrast, the recovery in non-core centres has been much more muted in Germany and the US, while in the UK and France there has been little or no recovery in values since 2009 outside of their capitals.
"Such a profile demonstrates the impact of four years of sluggish economic growth on corporate profitability. In the UK, 2012 was the worst year for retail failures since 2008, with 4,000 stores and more than 48,000 employees affected. 2013 could be as bad – surveys suggest 3 in 10 companies in the UK are currently loss making and 1 in 4 are either only paying interest on debt or struggling to pay on existing terms.
"Should investors be concerned? Clearly yes – jobs are at risk, local high streets are changing beyond recognition and European banks are rapidly withdrawing support from many businesses.
"That said recessions create opportunities for new firms, who can press ahead with innovation. A number of operators are still expanding or even developing new concepts and formats in which to sell their goods.
"Both retail and business sectors are part way through a technology revolution. In terms of shopping trends, this is driving demand for larger stores in ‘showcase’ locations, perhaps using ‘click and collect’, but also supports "niche" operators in local units who increasingly sell internationally through multi-media channels.
"The consequences are illustrated by the diverging statistics on retail investments. Since 2008, UK retail administrations have affected 25% of units in both regional shopping centres and high street locations. However, vacancies have increased by just 1% in the large regional centres compared to 3.5% in town centres. While voids on UK high streets average 15%, it is 19% for weaker secondary shopping centres but relatively stable at 8% for larger regional centres. This trend is replicated in the US where community and neighbourhood centres have seen empty floor space remain above 10% since 2009, while large regional mall voids trended down in 2012 to about half that level.
"A cloud does hang over parts of the market in the form of the ongoing unwinding of European bank loan books, often at distressed prices. Various estimates suggest European banks are 20% to 25% through this unwinding process, with about 1trillion euros of outstanding real estate debt. As in previous cycles, this is likely to be a six to seven year process, with the UK, Irish and Spanish markets having the most exposure.
"If we assume over the next five years banks cut their real estate loan books by 50%, in the UK this would translate to a possible £100billion of assets to sell. Such reductions could come in the form of either repayment of loans, write down of loans, sales of loans, sales of assets or even debt-for-equity swaps. Such volumes are high relative to the average trading of only £35billion per annum in the UK. The good news is that having analysed the information on bank loan books in the public domain, we can see a significant concentration of small, poor quality assets which are not within the core institutional universe. For example, less than 25% of the UK IPD universe (the main benchmark for commercial real estate in the UK) is in assets under £10million in size.
"In this environment, taking an active and selective approach to real estate investing is more important then ever. Making the right assessments of geographical trends, asset size and changing retail formats is a vital part of building a diversified real estate portfolio. However, if judged correctly investors may be able to capture a relatively stable income, with high running yields meaning annual returns between 6-8% a year are feasible, as long as the economy navigates a path into stronger growth."
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