In the private investor sector, the commercial property market is experiencing a disconnection between pricing and the underlying investment value of the property based on property fundamentals. A difference has always existed between the underlying value of a property and its value as an investment, but at least both values headed in the same direction. Now what is happening is that the price has taken on a life of its own regardless of fundamentals.
Investment is about becoming better off, so investment property fundamentals are growth-oriented; assuming the property characteristics continually in demand, rent payable for the premises on rent review to market rent and renewal of the lease will increase, or if the property is vacant then the rent on a new letting would be at least the same if not more than the estimated rent when the purchase was made.
Whether increase is achieved in practice depends upon a host of factors. Places change. Although the cushion of an upward-only review protects rent payable after a review to market rent is agreed or ascertained, there can be no certainty that the market rent would be a higher rent. Also, since market rent on renewal is without a cushion, the investor is at risk that the rent payable on a renewal lease would be less than before. All those factors can be taken into account in the purchase price of the investment and in theory, if not in practice, reflected in the yield.
It may be logical to compare the yield from commercial property investment with returns that are available elsewhere, but really property should be considered on its own merits, in isolation. Generally, the higher the yield the lower the prospects for growth, and vice versa.
Investment price differs from investment value. Price is whatever the market will bear, that is all: nothing to do with value. Price can be inflated using shrewd marketing and sales techniques, including the creation of readily-mortgageable propositions. So when a buyer compares the price and yield with the yield obtainable from other forms of investment and concludes that a proposition must surely be cheap, the momentum in that way of thinking will lift prices to a level that disconnects from property reality.
A change in the direction of the investment market caused by the prices paid by private investors in commercial property has disconnected the relationship not only between investment property fundamentals but also underlying rental values. An investment is supposed to encompass prospects for growth for the property as an asset but what happens when the investment is the investment itself?
Without an understanding of property fundamentals, it is much harder for an investor to differentiate between price and value. Buying on price, a reflection of interest rates, also thinking property the only safe haven, is why yield compression and demand can result in a higher selling price regardless of whether the property fundamentals have changed. When fundamentals are ignored, the more an investor pays for a property, the harder it becomes to maintain or increase that price without the support of investment market sentiment.
The investment market is awash with surplus cash. Auction fevered buyers throwing caution to the wind are falling over themselves to compete with one another to pay higher prices. For sellers of sought-after propositions, the investment market is red hot. For cautious buyers, concerned that top prices are unstable, it is natural to go further afield in search of better value, but the temptation to buy anything that looks cheap in comparison should be resisted. Tenant demand for commercial property in the provincial towns is weaker than in major cities and even in cities the criteria is location and leasing opportunities, rather than across-the-board. Since prospects for rental growth are a reflection of demand and supply, it should not be assumed that because the investment market is buoyant the rental market is likewise.
Traditionally, a property cycle rises and falls, up and down, peak and trough, but the principle requires a connection between the cyclists and the metaphorical road ahead. Essentially, using balance and harmony, the principle of a cycle is for turning dreams into reality. A disconnection between the price and fundamentals enables investors to skip over troughs; in the process turning dreams into nightmares.
By way of analogy, I reckon the prevailing commercial property investment market is playing games: a version of pass-the-parcel and musical chairs. In the fun game, the benefit of participation is the prospect of social profit (pleasure), the goal is to ensure a chair to sit on when the music stops. To begin with is the same number of chairs as players. The chairs are lined up back to back in two rows. When the music starts, all players walk around the chairs. At the start of the second round, one chair is removed. Without a chair to sit on when the music stops, one player is eliminated. For each round as the game progresses, another chair is removed, until there is one chair left: the person sitting on it is the winner.
In the commercial property investment market’s version, the benefit for participation is the prospect of financial gain. Unbeknown to mostly inexperienced buyers, only property that has gone ex-growth or heading that way is on offer. There are fewer sellers than buyers, and plenty of chairs for buyers. To begin with, the sellers are seated on the chairs. When the music starts, the sellers stand up and pass parcels of property to buyers. When the music stops, each buyer takes a parcel and sits down, any seller with no more parcels is eliminated. The game ends when all the property has been transferred between sellers and buyers. Unlike the fun version, when the music stops and interest rates and borrowing costs rise it won’t be the people out of the game that have lost out, but all the people sitting on the chairs.
The Rent Review Specialist