Mix up your portfolio
Mixed use is a popular phrase in UK in property circles at present. The urban renaissance agenda, pushed by local and national government, has moved planning policy towards creating environments which incorporate a variety of uses on sites whilst, at the same time, restricting the use of greenfield sites and encouraging the use of urban and formerly developed land. Rising values and a scarcity of previously undeveloped sites has made urban regeneration and redevelopment viable in many areas so large, strategic sites have been released onto the market. Developers have found, regardless of planning policy, that it is simply not possible to build out a large tract of urban land with a single building type. The clever ones have also discovered that mixed use development can add value too.
A major consideration for these developers, as always, is whom will they be able to sell their development to? In the past, their exit route has been assured. There has been no problem with selling residential units in the last decade – either to owner occupiers or residential investors and, provided an office building or a retail unit has a good covenant, there should be no problem offloading it to an institutional investor. But who will buy a building that incorporates shops on the ground floor, leisure below and offices above? And what if there is a stack of residential units above that lot as well?
The answer in the past, when it comes to the big investors, has been “not many”. Buildings comprising a mix of commercial uses only constituted 9% of all the properties in the Investment Property Databank database in 2003. Of the 6,536 properties in the IPD database, 596 have a significant mixture of two or more uses. Having said this, the situation is changing. In 2002, only 8% of properties in the database were mixed use.
The evidence from an analysis made by FPDSavills research suggests that investor appetite may be growing because mixed use schemes outperform single use buildings. The total returns for property in the selected, mixed use schemes were found to be higher than those for comparable properties in the same location in studies undertaken in both 2003 and 2002. The total return for property in mixed use schemes was 18% in 2002 and 14.2% in 2003 whilst returns on comparable single use schemes was 12.6% in 2002 and 13.6% in 2003. Over the medium term, mixed use schemes appear to have clear advantages over single use, showing total returns at least one percentage point higher over the last three and five years.
The out-performance of mixed use schemes seems to be driven by rental growth and capital growth. Capital growth has been driven by hardening investment yields for commercial property in mixed use schemes. Investment yields have fallen across all sectors (both mixed and single use) as the low interest rate, low inflation, economic environment of the last few years and the weight of money targeted towards the property sector has had its impact. In the case of mixed use development schemes, this effect has been more pronounced than for property in single use schemes – to the extent that yields on mixed use schemes are now lower than on single use ones. This is also true for single buildings with a mix of uses in them and has been a major driver of total returns for this type of property too. There are regional variations to this change in attitudes however, in London, mixed use yields are actually significantly lower than single use whilst in the north and Scotland, they are still higher.
There also has to be a question as to how long this type of outperformance can continue. The lower yields should be maintained for as long as investors expect continued rental growth outperformance from mixed use. It is very unlikely however that a great deal more capital growth will be experienced as a result of yield shift over the longer term.
Despite signs that the barriers are breaking down when it comes to investor attitudes, there are still barriers to development. Some of these relate to long-term infrastructure funding and some to medium-term development funding of high-risk sites. Short-term funding is much less of an issue. It is usually readily available at the point where an investor or lender can reasonably foresee an assured income stream in the near future. The cost of this funding (or the rate of return required by an investor) will be dependent on the perceived quality of the covenant (credit worthiness of the occupant or potential occupants) as well as the size and longevity of the income stream (rent) and the reversionary potential (value of the building at the end of the lease). There are also issues of suitability. Will the building suit the investor’s needs and fit with other properties in the portfolio? Will it be easily saleable to other investors or will it prove to be even more illiquid than other property classes?
Mixed use buildings have traditionally stalled on all of these criteria except the first. There is no evidence to suggest that occupiers of mixed use buildings or schemes should be any different to those in single use. There may even be some evidence to suggest that covenants may be more reliable inasmuch as diversity spreads risk and also that higher quality environments are more likely to engender good businesses. Our research on investment returns have shown that mixed use schemes and buildings are at least as adequate as single use and that the case for investment in mixed use buildings and schemes is becoming established.
The issue of suitability for property investors is perhaps a thornier one than performance. One barrier to direct institutional investment in mixed use buildings relates to the difficulties of adjusting property weightings appropriately when holdings consist of buildings in more than one use. We suggest that measures could be introduced to overcome this and it may be that the introduction of tax-transparent vehicles, such as UK REITs, could be used as a mechanism to separate out income streams for different uses thereby enabling a virtual mix of properties to be achieved within a portfolio without the need to buy and sell direct property. Another solution may be for investors to adopt mixed use as another distinct and separate use class in itself with its own special characteristics. We believe that there is a distinct place for mixed use property in a well balanced investment portfolio. Overall, short-term funding availability should not be a big issue for most mixed-developers. At the point where a cash flow will be delivered in the near-term, we expect that most existing finance institutions and investors will want to get involved.
Yolande Barnes is head of research at FPDSavills