UK &

Canada Real Estate Markets

-by
Adit Agrawal (13P185)
Kumar Nittin (13P212)

In

2000, directly owned real estate accounted for some 7% of the value
of the institutional investment market throughout the world
This represents the third largest market (at 12% of global RE market)
after the US ($380 billion, or 30%) and Japan ($217 billion, or 17%).
The cult of the equity has dominated western investment strategy in
the 1980s and 1990s to the extent that equities now dominate most
institutional portfolios, especially in the US, the UK and Hong Kong. On
the other hand, in Germany and some other continental European
countries, bonds have always been the largest component of the mixed
asset portfolio. In either case, property has been treated as the third
asset class.
UK institutions held over 20% of their investments in real estate in
1980. The average is now around 7%. There are two reasons for the
decline. First, the returns on property relative to equities were low in
the 1980s, so that the allocations to equities have increased as a result
of the unmatchable growth in the capital values of equity portfolios.
Second, the positive performance characteristics of property,
traditionally seen as reasonable return, low risk and a good diversifi er,
have been challenged.

Real estate investment: the

rationale
Property

is differentiated from other assets

by four main factors. First, it is a physical
asset, requiring maintenance and suffering
obsolescence. Second, its income delivery
is governed by lease contracts. Third, its
supply side is inelastic and is regulated by
both central and local government policy.
Finally, it is not traded in a centralised
market, and as every property is unique, it
is valued consequently without the benefi t
of direct reference to quoted trading prices
for identical properties.

Income through Lease

contracts
The

payment of rent is governed by the provisions of the lease.

The UK has begun to move away from the previously standard
25-year lease, which appears to favour UK landlords and to
suggest their peculiar strength in the market. The UK lease of
commercial property usually fi xes rents for fi ve-year intervals
with upward-only reviews, while continental European leases
often have rents indexed annually. Longer North American
leases may have rents tied to the rate of infl ation or, more
often, for retail tenants, to the tenants turnover; this is rare in
the UK. The rental pattern in the typical prime UK investment
property is therefore stepped upwards (in a period of infl ation
or growth) at fi ve-yearly intervals.
Rents at each review point are renegotiated in line with the
open market rent. It is arguable that market rents (ERVs;
estimated rental values) refl ect the fi xed nature of the review
period and are higher than annually reviewable rents would be.
Similarly, longer review periods will attract even higher rents.

Planning and supply

Unlike

equities, the supply of property is

regulated to some extent by central
government. Unlike gilts, the spatial
nature of property as an asset means
that local government also has a say in
the supply side. Unlike both, supply is
inelastic in response to economic
conditions. This has several effects, most
important of which is the exaggeration of
the well-known property cycle and the
occasional boom and bust.

The sectors: principal

characteristics
Commercial

property risk and return characteristics vary from

property to property and f
There are over 500,000 shops in the UK and thousands of
shopping parades. There are about 500 locations which attract a
reasonable spread of multiple retailers. However, there are only
100200 prime retail locations, typically with at least 100 shops
each and minimum catchment populations of 50,000 266
Institutional Aspects of National Real Estate Marketsplus. Highstreet shop unit values typically range from 100,000 to 5 million
and offer the potential for effective diversifi cation. rom sector to
sector.
As single tenant investments they are straightforward to manage.
They depreciate very little, as much of the value resides in the
land. Supply is restricted by the importance of the location, so
owners are protected from competition in many cases.
Nonetheless, smaller high streets have suffered in recent years as
shoppers have sought greater shopping choice and convenience in
out-of-town retail warehouses and shopping centres.

Retail warehouses and

parks
Highly

popular with the price-conscious, time-poor, car-borne

shopper in the 1990s, retail warehouses were the best
performing sector for investors through most of the 1990s.
Planning limitations usually restrict sales to bulk goods (DIY,
furniture, carpets, white goods). Single units have lost popularity
at the expense of retail parks, typically of 75,000150,000 sq ft
(1030 million capital value). The few retail parks combining
areas of 200,000 sq ft and more with open A1 (unrestricted
retail) planning consents can become open-air shopping centres
and command much higher rents. Rents in Fosse Park,
Leicestershire, the most notable example, are now 10 times the
rate of stand-alone DIY units in many locations. Good parking
and highway access are vital. Recent poor performance may be
explained by excessive buying pressure though the mid-1990s
and general doubts about the retail sector in the midst of the ecommerce revolution. However, out-of-town retail planning
consents have become increasingly diffi cult to obtain,
supporting investor interest.

Shopping

centres- Refurbishment, depreciation and service

charges for common parts are big issues for shopping centre
owners and their tenants.
Offices and business parks- Traditional town centre offi ces have
been the worst performing UK property sector over 30 years,
Depreciation and obsolescence have badly affected performance
as occupiers needs have changed and fl exibility of layout and
services has become the key issue. Many of the earlier buildings
have been incapable of providing air-conditioning and raised floors
for computer cabling
Industrials and distribution warehouses - Traditional industrial
estates have historically performed best late in the cycle: strong
performance following strong retail performance was a typical
pattern for the 1970s1990s
Residential- UK allocations to this sector are tiny but growing.
Traditionally excluded from the institutional market due to
legislative risks and small lot sizes. Returns have been high in
recent years but falling.

vehicles available for property

investment
While

many larger investors choose to invest by assembling portfolios

of buildings (segregated portfolios) or by appointing managers to do
the same (separate accounts), smaller investors may choose indirect
investment in property through the purchase of property shares or by
participating in pooled property vehicles.
These include illiquidity, the bias of pension fund minimum solvency
requirements against relatively illiquid assets, poor comparative returns
during the 1980s and 1990s, and a lack of trust in property return
indices.
The success of the REIT in the US has prompted many investors and
managers to encourage the creation of a similar quoted, taxtransparent product in the UK. Unfortunately, the UK government has
made it clear that it regards such a development as tax negative. In
addition, investing in property shares has tended to deliver
performance which is linked to the performance of the stock market
and fails to provide the diversifi cation advantages of property. Recent
work by ABN-AMRO also suggests that returns have been very similar
as for direct property investment, but for much greater risk. Hence, this
means of investing in property has become less popular in recent years.

The

UK has been no exception in its development of

securitised and other indirect forms of property ownership.
The packaging of listed securities into funds which provide
exposure to a countrys property sector, or to a region or a
sector, gathered pace in the late 1990s.
However, for the supply of property share funds to grow
requires growth in the number and size of listed property
companies. In 2000, market pressure in the UK was
operating in the opposite direction, as large discounts of
share price to net asset value made it more attractive to
take property companies private and exploit the property
values in other ownership formats whose performance is
unlinked to the stock market. Over the longest time series
available, property companies have outperformed direct
property investment by around 1.5% each year. Both have
signifi cantly underperformed the UK equity market.

Investment vehicles

Limited partnerships The limited partnership enables a pool of investors to invest together in one or more
assets. The number of partners was limited to 20 but is now unlimited.
While at least one, the general partner, must have unlimited liability, the other partners
may be limited. The investment is, therefore, passive and, importantly, the investment
itself is tax transparent.
regularly heard of in the UK property market since the 1990s.
In establishing the pool of capital required, the GP may appoint a promoter to raise capital
from limited partners (LPs); in some cases, the promoter may be the originator of the
concept and seek a GP to act as lead investors
Limited partnerships are tax-neutral or tax-transparent vehicles, meaning that the vehicle
itself does not attract taxation, and partners are treated exactly as if they owned the
assets of the limited partnership directly.
Although the legislation for limited partnerships has been in existence since the passing of
the Limited Partnership Act of 1907, conspicuously few were established as a vehicle for
property prior to 1997
The gross asset value of all the limited partnerships presently equates to approximately
14 billion. There is almost 4 billion of gross asset value in the top 10 funds
Limited partnerships do not appear to favour particular types of property over others, but a
key theme is that in many cases a fund will often be sharply focused on a single specialist
property type. Examples include Airport Hotels Partnership, Apreit V Nursing Homes and
MWBs leisure funds. Some are more similar to property unit trusts, diversifi ed
partnerships including Lionbrook Property Partnership, and the Threadneedle Tandem
Property Fund.

Investment vehicles

Property unit trusts

Managed funds

Property investment trusts - are listed investment trust

companies which specialise in property investment,
primarily by holding portfolios of listed property shares.
Property investment trusts have the ability to invest directly
in property, but direct investment is restricted

Special-purpose corporate vehicles and cross-border

structures- For a variety of reasons connected with fi
nancing, accounting and tax, many corporate vehicles have
been created as special-purpose vehicles for holding
property assets off balance sheet. In addition, some
property funds have been created in offshore corporate
form, but usually for the purpose of holding overseas assets
in a tax-effi cient way

Other trends

Decline of traditional owners- The structure of ownership (or, more

accurately, control) of UK commercial property has been changing in
both obvious and subtle ways over the last 25 years.
1. To take an example, the overseas ownership of City of London offi ce
buildings increased from around 35% to 2025% over the period from 1972 to
1998
2. there has been a less apparent shift in management away from the
insurance companies and pension funds which were so dominant in 1980,
when property made up as much as 22% and 12% respectively of their total
assets, towards fund managers and property companies

Property companies have been successful at surviving two severe

challenges to their existence, in 197375 and in 199193. In both
property recessions many famous property companies became
insolvent and disappeared. The extremely strong performance of the
stock market in the 1980s and again since 1993, coupled with a
growing demand for liquid (easily traded) property investment vehicles,
has provided some support to the albeit poorly performing share prices
of the survivors. However, the weighting of property companies as a
proportion of the stock market has declined significantly since 1989
and suffered greatly again in the technology boom of the late 1990s

Role of government
The

principal legislative and regulatory issues of

current concern to the UK property industry

corporation tax, capital gains tax,

health and safety law,
employment law,
accounting standards,
land-use planning system,
construction law,
landlord and tenant matters
Stamp duty - The industrys competitiveness is damaged
by charging capital invested in the property sector 4%
stamp duty while capital invested in the equities sector is
charged 0.5%. This issue distorts the effi cient working of
the market to the detriment of the industry and its
customers.

Other issues
Issue

of European Monetary Union

The UK government position on monetary union is complicated. It appears committed to entry,

but also to sticking by the outcome of a future referendum which appears unlikely to confi rm the
government position
EMU membership, when it comes, seems likely to have one signifi cant benefi cial effect on UK
property investment and for UK investors. It will eliminate currency risk for cross-border
European investors, and reduce currency concerns for global investors with pan-European
strategies
The

Commercial Leases Code- Following lobbying by tenants concentrated in the retail

sector, the UK government wants to encourage more choice and fl exibility in the
commercial property market and to promote a better understanding of property
matters, particularly among small business occupiers. In particular, the industry is
focusing on the long lease with upward-only rent reviews as a possible restraint of
trade. This led to the publication of the 2002 Commercial Leases Code.
The principal requirement of the Code is that landlords should offer fl exible and alternative
terms for consideration by a prospective tenant and for both parties to ensure that they have
obtained professional advice before committing themselves to a lease and fully understand the
basis on which the lease is issued. In assessing fl exibility and alternative terms, landlords are
encouraged to re- fl ect on the terms that they are prepared to accept and tenants are required
to ensure that such terms truly represent the circumstances upon which they are prepared to be
bound during the course of the lease. Where alternative terms are offered, rents will differ
accordingly. The market has already moved forward considerably from the days when the
standard 25-year lease term was adopted by both landlords and tenants, regardless of the
circumstances. Nonetheless, the government is hoping to encourage more leases of short
duration. Break clauses are an effective compromise.