Property Investment Theory

A Macleary, A. Macleary, N. Nanthakumaran

• Publisher: Taylor & Francis
• Year: 2003
• eBook ISBN: 9781135834203
• Topic: Business
• Subtopic: Business General
• Index: Business

This up-to-date reference on property investment highlights the problems with existing techniques of property valuation and appraisal and identifies possible ways forward for both research and practice.

CHAPTER 1
PROPERTY AND INVESTMENT

1
Property and Investment in the UK

The property market in the united Kingdom is a vigorous one and it is one which has undergone distinctive patterns of change. The dynamics of change continue and apparently accelerate. The volume of funds invested in property have grown by an enormous amount over the last twenty years. Much new investment over the last decade has been into residential mortgages and this reflects the quickening pace of owner-occupation encouraged by the present Government. Investment in commercial property (with which we will be concerned) has shown less spectacular but nevertheless impressive growth.

Together with equities and government securities property has established itself as a major component of institutional portfolios subject to continuous scrutiny of its comparative advantage against these other investment media. As a consequence property is now a subject of considerable importance to financial institutions, as well as to property companies and banks.

However, in achieving this status with the investment community property has ridden a roller-coaster courtship of heady euphoria followed by deepest despair. It has changed suitors on a number of occasions according to their perception of its dowry or its perception of their virility. It remains enigmatic in respect of many of its characteristics and stubborn in its refusal to submit to detailed analysis.

The reluctance of property to reveal explicit facets for precise determination has not always been the fault of property. Investors have often enough been prepared to seek a hasty marriage of convenience without much regard to the marriage contract. But property is now firmly wedded into the family of investment media. Maturation and respectability permit the giving up of secrets and a greater willingness to accept accountability. Indeed it may be suggested that if property does not satisfy investors with the information they require then it risks being spurned in favour of competing investments which may look more attractive to investors, particularly in the short term.

Figure 1 Institutional Investment in Property

In making this somewhat frivolous analogy with the flighty temptress who inevitably becomes the respectable lady it is possible nevertheless to highlight the nature of the property investment dilemma and to isolate those characteristics of property which have given and often continue to give difficulty or to be misunderstood.

In order to set the scene for the particular issues addressed by later chapters it will be necessary to outline briefly the history of investment in property and to consider the nature and behaviour of the principal investors in property.

2
The History of Property Investment in the UK

A number of writers have provided clear and concise accounts of those significant events which have happened to or have been caused by property in the recent past. (Darlow and Brett: 1983, Fraser: 1984, Mclntosh and Sykes: 1985). There is general agreement amongst these writers that the main events included the following:

1965–73: the property boom

A distorted property market (essentially caused by the Control of Office and Industrial Development Act 1965) resulted in under supply of commercial space and spiralling rental values. As a consequence of this overheating of the market property companies became subject to take-over bids (encouraged also by the Capital Gains Tax Act 1965 and the introduction of Corporation Tax). The movement of pension funds into property (see p.) encouraged the boom which was further fuelled by the expansionist policies of the then Chancellor of the Exchequer, The Hon. Anthony Barber. His budget of August 1971 unleashed credit expansion and inflation. British industry failed to respond to the opportunity for cheap capital investment and the banks lent instead to property companies. Such lending almost quadrupled over the four year period (£800m start 1972 to £3000m end 1975) and the rapid growth in lending to property companies emanated in particular from secondary banks. In retrospect this sharp upward trend in debt financing was the main destabilising factor in the commercial property market. But initially high rates of inflation (moving from 8% in 1971 to 20% in 1973) with consequential rises in rack rents together with high rentals at the margins of the office market on uncontrolled prime space encouraged a belief that (already overvalued) properties would sustain capital values at a rate of increase higher than inflation. Rates of interest were not seen as being critical in these circumstances and the secondary banks became increasingly committed to property and hence lending long while borrowing short. But that did not matter—property was a good investment!

1973–74: the crash

In late 1973 the established economic order was thrown into confusion by quadrupling oil prices thus further increasing inflation and critically undermining economic policies designed to enable a ‘dash for growth’. Within days minimum lending rates shot up to 13%, severe credit restrictions were brought in and development gains tax was introduced. As a direct result of these economic shocks the consumer boom came to an abrupt halt and with it the demand for commercial floor space. Property companies were now fearfully exposed. They were faced with steeply rising short-term interest rates while their rental income remained static. They could not obtain further borrowing and they could not sell. Companies caught with large development programmes were particularly hard hit because, in the midst of all this adversity, they were faced with rapidly escalating construction costs. Capital values fell sharply. The property companies were highly geared. It was essential that they liquidate assets to repay debt. But there were no buyers. Financial institutions who might have bought cheaply were getting a better return on the money market (with high rates) and probably took the view that, in the circumstances, property would become even more cheap. Urtable to sell and raise cash property companies defaulted on loans. Secondary banks unable to recover debt became bankrupt. On the 30th November the London Stock Exchange suspended trading in the shares of London and County Securities. The Bank of England was constrained to undertake a rescue operation to save the secondary banks—and hence the credibility of the City itself.

Figure 2 Insurance companies’ and pension funds’ property investment as a percentage of net assets

The story may not be an edifying one from any particular viewpoint but one can appreciate how it comes about that property is seen as the bête noir in the process. It is certainly the case that ignorance of those factors which affect property investment and/or an inability to measure such effects was a major contributor to many of the unwise investment decisions that were made.

1974–82: the expansion of institutional investment

By far the most dominant investors in property are the financial institutions. Insurance comanies and pension funds historically invested in fixed interest securities (because of the restraints of Trust Deed rules). However, since the last war institutions increasingly invested in property as it became clear in the 1960’s that growth in both income and capital could produce a greater overall return than fixed interest securities—hence the emergence of the ‘negative yield gap’ where apparently riskier equities were displaying lower yields than gilts but where the redemption yield would be higher.

For the same reasons financial institutions began to show an increasing interest in property as they saw both rents and capital values rise, particularly during periods of high inflation. There were other reasons for increasing their involvement in property. The sheer volume of money flowing into these institutions meant that any investment medium was in demand (e.g. the amount of savings handled by the financial institutions in 1957 were £7bn, by 1987 it was £36bn). During the sixties the practice of commercial property development moved towards the introduction of shorter occupation leases and more frequent rent reviews. The imposition of credit restrictions caused property companies to turn to the financial institutions. Arrangements such as sale and leasebacks were proving to be attractive to both parties. The cumulative effect of such beneficial changes in the property market was a greatly increased interest in investment in property.

However, until the 1970’s the financial institutions, interest in property was mainly expressed by the acquisition of shares in property companies. After the crash of ‘74 it was possible for institutions to increase their property holdings by purchasing at low cost the assets of those property companies which had got into difficulty. Direct investment in property was seen to carry with it the benefits of greater control of the asset and greater security of an income which was untaxed in the hands of the pension funds and life insurance funds.

These factors culminated in a period of significant acquisition of property investments by financial institutions in the period 1975–1982. During that period the total property assets of financial institutions rose from £7bn to £27bn. The proportion of property investment as a part of the total portfolio of financial investments was at or near 20% during this period.

1983–87: the maturing of the property investment market

Since 1982 quite significant changes have occured in the property investment market. The total value of the property assets held has continued to increase over this period but the rate of increase has been very much less rapid. During this period net annual investment in property has fallen from about £2bn per annum to £lbn per annum and the proportion of institutional portfolio structure has also roughly halved over that period (from 20% to 10%), with the share of net annual investment falling to 5%.

A number of reasons for this apparent disenchantment with commercial property investment can be readily identified. Some funds may have already achieved their target for long-term property assets in their portfolio. During this period there has been sustained a relatively low rate of inflation combined with an unprecedentedly prolonged bull market in equities shifting comparative advantage from property and gilts to equities. This has undoubtedly been the principal reason, that is, the low return available from property relative to other investments. As well as the boom market in equities in the United Kingdom, overseas investments were running at a high level. With high rates of interest and real rates of return short term assets have been more attractive.

Figure 3 Institutional net annual investment (pension funds and insurance companies)

Indeed during 1987 pension funds became net disinvestors in property for the first time although the commercial property market has remained buoyant. This relative disenchantment with direct property investment by financial institutions also introduced factors other than concern about rates of return and opportunity cost. Doubts were emerging about the suitability of property as an investment. These doubts focused on several areas.

Firstly, there was concern about the method of valuation of property assets. Leading analysts were concerned that traditional methods of valuation may have proved to be not as useful as more explicit discounted cash flow analysis in determining worth at any given time. Certainly the crash of ‘74 and its repercussions caused considerable disquiet in this regard (see Greenwell Montague: 1977, for example) and the debate continues to the present time (see Chapters 2 and 3).

Secondly, there was increasing disquiet about the illiquidity of property investments. This referred in part to the cutting back of investment where performance is poor (such as agricultural land in the recent past), but also to the fact that, even for large financial institutions, direct property comes in large indivisible amounts.

Thirdly, there was increasing disquiet about the incidence of depreciation and/ or obsolescence in property and its financial implications for the investment. An original article by Bowie:1982, claiming a reduction in yield from a prime office investment from 4.5% to 3.9% net of depreciation, is reputed to have had a direct effect on property investment activity. Subsequent work by Debenhara Tewson and Chinnocks:1985, Salway:1986 and Jones Lang Wootton:1987a has further clarified the nature of obsolescence and its measurement. In Chapter 5, Baum uses evidence from a City University study to confirm the nature and characteristics of depreciation and to suggest that identification of depreciation as a third variable is a further argument in support of explicit appraisal of property investments.

During this period financial institutions were therefore becoming more immediately aware of the unique characteristics of property. They had always understood that imperfections in the property market included lengthy and comparatively expensive transfer times and costs, or that property markets were local and often thin and volatile. But they were now becoming increasingly anxious that details of transactions in the market were not easy to come by or that there was no readily available index of current or past prices. As a consequence it was difficult to analyse risk in property investments.

To be sure the leading firms of chartered surveyors had begun to produce indices of rental, capital and yield performance to attempt, however inadequately, to fill the gap which the absence of an ‘All Property Index’ designed to supplement other accepted indices has left, and which could never really be filled because of the very nature of property markets.¹ While these indices are useful and while they are primarily concerned with instituti...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Notes On Authors
• Acknowledgements
• Introduction
• Chapter 1: Property and Investment
• Chapter 2: Valuation Techniques: A Matter of Evidence and Motive
• Chapter 3: The Current Discounted Cash Flow Models for the Valuation and Analysis of Property Investments: An Examination of Some of the Problems
• Chapter 4: Depreciation and Property Investment Appraisal
• Chapter 5: The Analysis of Risk In the Appraisal of Property Investments
• Chapter 6: Forecasting of Rents
• Chapter 7: Portfolio Theory and Property Investment Analysis
• Chapter 8: Asset Pricing Models and Property As a Long Term Investment: The Contribution of Duration
• Chapter 9: Advances In Property Investment Theory
• Appendix: Advances In Property Investment Theory: Two-DAY Seminar, 18 and 19 February 1988
• Symbolic Dictionary