sample essay

1 © Hussein Hijazi 2016

FINANCIAL AND ASSET MANAGEMENT 2015-6

Hussein Hijazi Sample Essay

Each student will provide a report of circa 3000 words on the following;

‘Discuss why the market value of commercial property can rise and fall over time, in

particular over the last 8 years. Does pro-active management improve return? Give examples where capital values change and where overall return changes.’

Within the property industry, commercial property is a unique sector, as stated by (Brett,

M. 1997, p 5-10) commercial property carries sixteen characteristics that make it unique

as an investment asset. Commercial property, within the context of this paper, is

classified as “a resource with economic value that an individual, corporation or country

owns or controls with the expectation that it will provide future benefit.” (Investopedia,

2003). Therefore, the reasons as to why the market value of commercial property (capital

value) can rise and fall depends on a number of factors.

(Brett, M. 1997, p 21) states that capital values can rise and fall based on numerous

factors that affect the yield associated to the property, which in turn is determined by

growth expectations, and the value of the rent associated with the property. These

factors are thus influenced by the key players that make up the structure of the

commercial property industry; occupiers, developers and investors (Key et al., 1994).

These players are further affected by several external factors, which influence their

combined decisions, which thus affect the capital value of commercial property overtime.

As a general rule, capital values are inversely related to yields and positively related to

rental values. This is shown in the formula below.

(Baum, A., 2009, p 5) states “As with all equity-type assets, the performance of property

is ultimately linked to some extent to the performance of the economy, and like all assets,

its performance is linked to the capital markets.” (Baum, A., 2009, p 5) continues to

state that occupier demand is driven by the state of the economy, and the rents paid by

occupiers is what produces investment returns over the long-term for investors. In the

short-term, however, investor returns are more likely to be explained by yields and the

individual returns that investors expect from their property investments. These demand

side factors by investors and occupiers influence the supply of commercial property

through affecting the decisions made by developers within the market. The interlinkages

of all these factors are illustrated in Figure 1 below.


Before examining the determinants of change in commercial property market values over

the past eight years, i.e. from 2007, a theoretical framework will have to be established,

for which relevant market data can be assessed against. (Dobson and Goddard, 1992,

pp 302-310) conducted a comprehensive study that incorporated a substantial

development of the theoretical determinants of commercial property prices and rents.

They examined both the demand and supply side of the market, for which several

assumptions and causal links are drawn. These are briefly discussed below.

From a demand occupier perspective, it is assumed that in order for the occupiers to

afford to buy or rent the property, they will have to make a level of profit that will either

cover the cost of rent or the cost of buying; interest payments made on loans to support

buying. As a result, the payment for rent or interest for buying will depend on whether

a sufficient level of profit is generated to cover these payments, for which the level of

profit depends on the performance of the economy. From an investor’s point of view, the

rate of return the investor requires will depend on the market interest rate. The rate of

return is dependent on the income the investor receives from the property over time,

whether in rents paid by occupiers or the increase in the capital value of the property

after holding the property for a set number of years.

From a supply side perspective, the higher the expected price or rent to be achieved by

commercial properties, the higher the supply of properties onto the market and vice

versa. The supply of property further depends on the expectations of growth in capital

values. Additionally, from a developer’s perspective, the costs and subsequent

prices/rents associated with commercial properties, pre and post development

respectively, affect supply of property onto the market. This is in association with the

availability of credit within the market for developers to commence with development

projects and the demand for property from occupiers and investors.

Market Value

Yields Rent Growth/ Return

Expectations

Occupiers Investors Developers

Economic performance/Market conditions /GDP

Demand Supply

Figure 1: Interlinkages of all factors affecting commercial property market value


As a result, based on the theory by (Dobson and Goddard, 1992) it can be said that at

market equilibrium, i.e. where the demand for commercial properties equals the supply

of commercial properties, then it can be assumed that capital value is at the market

clearing price, i.e. the market determined price. Any shift from this equilibrium due to

changes in the factors affecting demand and supply, cause changes in market values of

commercial properties. Thus, in examining the trend of the changes in market values

since 2007, the charts under the Appendix section of this paper are examined in

conjunction to various market studies and publications.

Before the onset of the global financial crisis in 2008, commercial property valuations

were at an all-time high, as shown by the commercial property price index (Appendix 1),

with valuations reaching their peak in 2007. Concurrently as demonstrated under

Appendix 1, the value of lending by banks for commercial property was above 20% of

GDP, i.e. the commercial property market was highly leveraged and dependent on credit.

Following the collapse of the global credit system, due to the sub-prime mortgage crisis

in the US, an increase in commercial real estate debt write offs by financial institutions,

shown in the chart under Appendix 2 from 2008 onwards, caused a drop in the capital

value of commercial properties (Benford, J. and Burrows, O., 2013) and (University of

Ulster Real Estate Initiative, 2009).

According to (Ulster Real Estate Initiative, 2009, p 49), income returns from commercial

properties continued to grow throughout the financial crisis “due to lease structures”, i.e.

where the majority of commercial property leases contained upward only rent reviews.

However, as explained by (Dudovskiy, 2013), the financial crisis caused a significant drop

in consumer spending within the economy (Gittins and Luke, 2012) (Appendix 3), thus

impacting projected revenue received by occupiers of commercial property subsequently

affecting the level of profit that they make. Thus, reflecting back on the aforementioned

theory, a drop in occupier profit will result in a reduced demand for commercial property,

as rents become unfeasible (Dobson and Goddard, 1992).

Additionally, the failure of several businesses throughout the financial crisis contributed

to an increase in the supply of commercial properties (Wood, 2010). The drop in demand

and increase in supply means “more space available for let becomes vacant and this

spare capacity adds to downward pressure on rents” (Benford, J. and Burrows, O., 2013,

p 50). The resulting fall in rents added to the downward pressure on capital values, as

shown under Appendix 4 in 2008, coupled with a slowdown in rental growth forecasts

post 2008 as shown in Appendix 5. The changes in capital growth resulted in an opposite

increase in property yields, as shown in Appendix 8. Furthermore, as shown under

Appendix 12, at the peak of the market, the value for new construction orders was above

£24billion in 2007. However, with a decrease in occupier and investor demand for

commercial property leading to a decrease in capital values, in conjunction with restricted

lending, the demand for new constructions collapsed significantly from 2008 to 2009,

and continued to fall until 2013, meaning that developers reduced the supply of new

space into the market.

A further explanation into the why capital values change lies in the manner in which the

market calculates the value of commercial property. “The value is calculated as the net

present value of future rental income, discounted by a risk-free rate plus some ‘risk

premium’ demanded by investors.” (Benford, J. and Burrows, O., 2013). This method

used in valuing commercial property is the dividend discount model (DDM) which “breaks

down changes in nominal property valuations into changes in rental values, expectations

for rental value growth and the risk-free interest rate. An increase in rents — or expected

future rents — leads to higher property prices, as does a fall in the risk-free rate.”

(Benford, J. and Burrows, O., 2013, p50) and vice versa. Therefore, a change in any of


the variables within the DDM, will result in a change in the capital value of commercial

properties within the market.

As a result of the financial crisis, the Government took corrective actions in order to

reignite the economy. Chief amongst which is the drop in the Bank of England base

interest rate, in order to facilitate lending amongst credit markets again, where in 2007

the base rate was at its peak at 5.75%, which was reduced gradually to 0.5% in 2009,

the lowest level for over 100 years (Appendix 7). The resulting decrease in the interest

rate resulted in a net increase in the lending to the real estate market, as shown in

Appendix 9. Furthermore, with an improvement in other economic indicators such as

household spending (Appendix 3), increase in employment (Appendix 10) and a recovery

of investment in commercial real estate (Appendix 11), commercial property values and

rental growths recovered post the financial crisis as shown under Appendix 8.

Therefore, it can be said that as stated by (Baum, A., 2009, p 5) and as demonstrated

by Appendix 6, capital values can change with changes in the health of the economy and

changes in capital markets, which are thus affected by changes in demand by occupiers

and investors who thus affect the supply of property by developers. The number of

variables and factors discussed above are in no way exhaustive. Indeed several other

contributors to changes in commercial property prices have been omitted or not

discussed for simplicity. Examples include inflation, government bonds and gilts, and

foreign direct investment into the UK commercial property market.

Yet changes to market values can also be experienced through pro-active or active

management of a property or a property portfolio. As stated by (Brett, M. 1997), within

the characteristics of commercial properties is that they are of large individual value that

depreciate over time. Thus, as an investment, active management can improve the

returns that an investor experiences from his property through, for example, refurbishing

or redeveloping the structure or negotiating more favourable leases that will yield a

higher return for the investor.

(Hoesli and MacGregor, 2000) state that the purpose for active management is to

“increase performance and to control risk”, which can be achieved by actively studying

the market, which is assumed to be inefficient, and employing “superior research” to

outperform that inefficient market. Active management, involves the employment of

active management skills in order to “achieve above market performance by careful risk

management”, also known as the process of adding value. Adding value to a property

portfolio can take two forms that involve either setting the share structure and stock of

properties in the portfolio or actively managing individual building stocks through, for

example, refurbishments or developments (Hoesli and MacGregor, 2000).

In setting the share structure of the portfolio, a decision will need to be made into the

determination of how much is to be invested into the different categories of the market,

i.e. retail, offices, industrial, etc. The structure thus determines the different stock of

properties to be held. Therefore, in order to determine whether the portfolio is

performing, a certain benchmark will have to be set against which to measure the

performance of the portfolio. It would be ideal to set the performance benchmark as the

average performance of other competitors, thus providing an objective for the portfolio

to outperform competitors, thus attracting investors. However, as it is a characteristic of

the commercial property market, no single market exists, thus the dissemination of

information is limited due to no requirement for the disclosure of transactions between

parties (Brett, M., 1997), making it difficult to set a competitor benchmark. Therefore,

assessing performance against a market index can be an ideal alternative. (Hoesli and

MacGregor, 2000).


In order to achieve the best returns and to continue adding value, the process of modern

management, as described by (Hoesli and MacGregor, 2000), can be applied. This is the

combination of effective structure setting and stock selection that seek to add value

through assessment of performance against a benchmark by active management, where

different valuation and pricing models are applied in order to determine which buildings

to buy or sell. Thus, in order to achieve effective modern management, the fund

manager(s) will need to: (1) set a clear statement of objectives; (2) analyse the portfolio

against the relevant benchmark; (3) effectively forecast expected returns and associated

risks; (4) considering the opportunity cost of achieving objectives i.e. what are the results

if no action is taken; (5) take into account other practicalities such as planning

permission, market conditions, lease structures, etc; and

(6) a clear strategy into what the portfolio is aiming to achieve through what means.

An example of an organisation that employs modern active management to its property

portfolio holdings is The British Land Company plc (BL). BL is one of Europe’s largest real

estate investment companies that own, manage, develop and finance a £13.6 billion

property portfolio (Britishland.com, 2016, About Us). BL has continued to employ active

asset management techniques, primarily revolving around refurbishment of stock,

development of new buildings and lease negotiations. These examples are discussed

below.

In 2009, BL undertook a £12 million refurbishment of 20,000 sq ft of office space at 338

Euston Road, one of its buildings in its landmark Regent’s Place estate, as a result of

which they were able to acquire an increased rent. Additionally, from a lease term

perspective, BL let 55,000 sq ft of office space on flexible short term leases, while they

make a decision of redevelopment or refurbishment of their office building at 4

Broadgate, thus sustaining income while holding the property (British Land, 2009, P16).

In 2013, for example, BL recognised that most of its development projects are

approaching completion. Therefore, with the market forecast to grow and in order to

sustain future income streams, BL acquired a number of sites such as the Clarges Estate

in Mayfair and the Hempel Hotel in Bayswater for a potential residential development.

Furthermore, BL submitted a revised planning application for the development of the

Clarges Estate, after an agreement was made to relocate the Kennel Club’s headquarters

into the estate, which will be part of a 193,500 sq ft mixed-use scheme (British Land,

2013, p 23).

In 2015, BL recognised the importance of technological advancements and changing

occupier requirements, by stating that their strategy “is to focus on assets which are

internet resilient and in tune with modern lifestyles” (British Land, 2015, p 42). This is

in conjunction with a £14.5 million refurbishment of Crystal House block and Next store,

located adjacent to their Ealing Broadway Shopping Centre, to include improved food

and beverage offerings to visitors and the introduction of new tenant occupiers. BL

reported that through active management, the Expected Rental Value (ERV) since

acquiring the site has grown by 19%. (British Land, 2015, p 42).

One of BL biggest demonstrations of active management over a sustained period of time

is their continued investment and development of their Regent’s Place Estate. Regent’s

Place is 13 acre site in Euston Road, London, that was acquired by the company in the

1980s from the Crown Estate (Ijeh, I., 2010). The company started major development

of the site in 2007, by building 10 and 20 Triton Street, and in 2009, Regent’s Place was

valued at £529 million and a rent passing of £39 million per annum with development

projects in the pipeline. These include Osnaburgh Street, comprising of two office

buildings with 151 residential units, and the North East Quadrant, for 380,000 sq ft of

office/commercial space and 171 residential units. (British Land, 2009, p 48).


What makes Regent’s Place unique in demonstrating BL’s excellence at active

management is through the manner in which the space was developed. All occupiers,

investors, the local community, environmental considerations and other stakeholders

were involved throughout the development process. In its 2014 report, Regent’s Place

at 30, BL demonstrated the extent of stakeholder involvement and consideration in an

effort to increase capital values and rents, while sustaining tenant occupation, ensuring

a continued income stream with a substantial increase in its goodwill asset.

Examples include regenerating the area through the investment of over £50 million,

putting Regent’s Place and the surrounding area within the top 1% for reductions in

depravation. Furthermore, the building of new walking routes to ease access including

the installation of substantial artworks. Additionally, the focus on sustainable

development was publicised, with all of their buildings achieving BREEAM ratings of

Excellent, including the building of green spaces within the heart of London’s West End,

such as the creation of 50,000 sq ft of green roof space.

All of the above investments made by BL resulted in Regent’s Place evolving to become

a major mixed used campus, with 1,600,000 sq ft of mixed use space with an occupancy

rate of 98.8% with a rent passing of £73 million per annum (Britishland.com, 2016)

(Appendix 13). Key occupiers include Facebook, Debenhams, ATOS, Gazprom and Aegis

Group (Britishland.com, 2016).

Upon reflection of the discussion above regarding the market value of commercial

properties, it can be said that the substantial interrelationship of all factors make

management of property as an asset to be quite complex. For example, in Figure 1 above,

the flow of effects between the various elements does not necessarily stream as exactly

illustrated. In fact the factors affecting market values can flow in exactly opposite

directions to what is illustrated in Figure 1, as the market value of commercial property

tends to change before the changes in market conditions can take place due to

speculation or a lack of investor confidence, thus, commercial property values have

sometimes served as indicators of the impending contraction of the economy.

On the other hand, an investigation into the effects of active management on the value

of commercial properties has proved to be quite interesting. As demonstrated by the

active management efforts of BL, it is now not sufficient for the investor or portfolio

manager to only hold practicable surveying and investment analysis skills. Active

property management has indeed evolved over time to become and art form in its own

right, demonstrating the level of expertise needed and the importance of stakeholder

consideration into attracting occupiers, negotiating lease terms and the importance of

continuous development in order to sustain increased market values and overall returns.


References

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Appendices

Appendix 1

Figure 1Source: (Benford, J. and Burrows, O., 2013)


Appendix 2

Figure 2Source: (Benford, J. and Burrows, O., 2013)

Appendix 3


Appendix 4

Source: (GVA|Bilfinger, 2015)

Appendix 5



Appendix 6


Appendix 7

Figure 3Source: (Bank of England, 2016) (Cushman & Wakefield, 2015)


Appendix 8


Appendix 9

Appendix 10


Appendix 11

Appendix 12


Appendix 13

Source: regentsplace.com/contact-us

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