The often-quoted mantra that “past performance is not an indicator of future returns” is one we should be mindful of in assessing pricing and capitalisation rates or yields in the property market.
Some commentators say Dublin is looking overpriced relative to long-term patterns. Others say the market is overheating on the basis of some assets that have sold for more than their indicative guide prices. If the investment market is overpriced or in danger of overheating, why are investors continuing to invest?
Opportunities
The reality is that assessing the appropriateness of a yield or a return from property investment is a function of market conditions at a particular time and is largely influenced by factors such as the availability and cost of funding at that time and the returns being achieved from other forms of investment or from property in other jurisdictions. While prime commercial property yields in the Irish market have certainly contracted sharply over the last 12-month period, a similar pace of yield contraction has also been experienced in many other European property markets from the cyclical high as a result of an increasing volume of funds chasing property investment opportunities across Europe.
Many long-term investors find property attractively priced relative to other investment alternatives such as government bonds or bank deposits, particularly considering the rental growth and future development potential associated with many property investments. Their rationale for investment is primarily determined by the return achievable from property compared to other forms of investment (taking into account a risk premium for property to allow for illiquidity and holding costs). Analysis that focuses solely on where yields stood at the peak relative to today is essentially meaningless considering that the market was radically different then.
Over 50 per cent of commercial property investment in Ireland is emanating from international investors seeking investment opportunities across a range of markets. Yields in Dublin remain competitive relative to other jurisdictions, particularly those prevailing in other “distressed markets” such as Spain and Portugal as there is a risk that some investors will look elsewhere for opportunities if the Irish market looks expensive by comparison. During Q1 2014, prime office yields in Dublin were approximately 5.25 per cent, which according to CBRE Research is not vastly different to prime office yields prevailing in many other European markets, many of which don’t have the economic growth prospects that Ireland does in the short to medium term.
Investors should focus attention on what yields are being achieved in other competing locations and from other forms of investment. Against this backdrop, investors also need to be mindful of the fact that property is currently attractive relative to bonds but as bond yields and interest rates rise over the next few years, as they inevitably will, this relative attraction of property will ease.
Real estate is not homogenous. Two identical buildings (even on the same street) will have two completely different risk and return profiles, influenced by factors such as their location, age, type, configuration, design, layout and last but certainly not least, the prevailing lease. Recent media coverage about a building achieving a dramatically higher price in 2014 than what it traded for in 2013 failed to recognise the significance of the fact that the lease in the building had been radically restructured in the meantime, which was largely the reason why the value of the asset had increased in the intervening period. Comparing initial yields or crude “price per square foot” analysis for different buildings without having regard to the inherent differences in the buildings and the terms of the leases attached to them is incorrect and misleading.
Criteria
Different investors have different investment criteria and will assess opportunities in different ways. Focussing on long-term average pricing in one jurisdiction and concluding that an asset is currently overpriced or indeed underpriced in comparison is clearly not thorough enough a methodology to determine appropriate pricing in a market that is vastly different to what it once was.
Marie Hunt is head of research at CBRE
