Commercial property returns are divided into income return and capital growth. Over the long term, two thirds of returns have been derived from income. Income return is driven by occupational markets; the demand for operational space for businesses and trading space for retailers. The growth and resilience of income is therefore crucial for long term outperformance and investment success.
We can divide local authorities with property performance data into quartiles based on historic employment growth. Concurrent property performance, measured by total return, is clearly associated with employment growth. The magnitude of the differential is notable and, although Covid-19 does have a displacement effect over the last five years, over the long term we would expect this relationship to hold.
There is a wealth of academic resource UK is focussed on explaining local economic differentials. Education is championed by many, but one of the most well-known protagonists is Professor Edward Glaeser from Harvard. He has consistently found education to be the best predictor of subsequent economic growth and that this has profound implications for public policy. There is a conflict, he claims, between investing in “vanity infrastructure projects” versus education (at all levels).
We find that the majority of recognised growth drivers hinge on the skills of both the population and the workforce. This has been found to be self-reinforcing: the higher skilled an area is the more likely it is to remain so. Besides education, other factors identified by academia include infrastructure; entrepreneurship (a thriving business climate); mobile labour (better educated labour tends to be more mobile) and finally – and less measurable – a sound political economy with a level of fiscal autonomy. These factors explain productivity; productivity drives output, and output drives employment.
By regressing local characteristics with employment growth, we can identify what combination of factors explains most of the differences between employment growth at a local level. This relationship can then be applied to present day economic and demographic characteristics to determine a forward-looking assessment of an area’s long-term prospects. There are aspects of local performance such a method cannot capture empirically, the key ones being local policy or the effectiveness of governance. In addition, we cannot capture consistently the pipeline of major developments in the planning system which may make a difference to an area’s prospects. However, this can be an overlay based on experience.
There are instances where an area has a high proportion of students and a low proportion of residents with a degree. In our view, this is evidence of market failure: graduates are not being retained and we can call this ‘talent leakage’. This is most likely due to job prospects but will also be influenced by real estate – the physical ability of an area to house and attract the knowledge-intensive companies to employ the area’s graduates. Direct investment into knowledge-intensive sectors could, according to theory, lead to a greater retention of graduates and better long-term prospects for overall employment growth. In our view, this would reinforce property performance.
In summary, we believe a detailed approach to understanding the drivers of employment growth and the application of this to determine future expectations can create a competitive advantage in direct property investment. Local areas most likely to outperform over the long term can be identified, and mispricing to the upside or downside can be exploited. It can also identify longer-term regeneration needs by focusing on areas with a key ‘missing ingredient’.
Investors’ motivations vary. Investors will have different costs of capital, risk tolerance, and duration. A framework can help link these different pots of capital to appropriate destinations by, for instance, identifying ‘performers’ which will have a strong track record but are more likely to be keenly priced or ‘regeneration need’ where significant, patient, capital may need to be deployed but where there is conviction on long-term prospects.
