Investment Strategy:  Second Quarter – Commercial Property

  • The last decade has shown that Commercial Property can bring welcome diversification and decent returns to investment portfolios with the daily dealt ‘bricks and mortar’ property unit trusts inching higher virtually every month to produce significant returns when accumulated over a number of years. What’s more, these returns have been remarkably consistent with virtually no volatility and a low correlation to the equity market.
  • There is through a ‘but’……illiquid assets in a liquid vehicle can be a recipe for trouble as 2008 and 2016, in the aftermath of the Brexit vote showed, leading to the funds being temporarily ‘gated’ (closed to redemptions), sometimes with the addition of severe markdowns to the net asset value. This is because, unlike equity and bond funds which price at a single price, property funds have a large bid/offer spread (i.e. you frequently redeem units at a price of around 6% lower than you buy units) because of the costs involved in buying and selling commercial property assets. Nor is this spread fixed, and it can widen significantly in times of stress, such as post the 2016 referendum vote.
  • This leaves us with a quandary. There is a possibility that investors will panic out of the sector in the event of a disorderly Brexit, as they did post the 2016 vote, meaning that funds could again be forced to gate for several months whilst they sell assets to meet redemptions. This will mean we will not be able to buy or sell the fund. Should we sell in advance of this possibility? We have decided on balance not to, we continue to value commercial property as an asset class underpinned by income and believe it will produce solid, consistent and diversified returns to client portfolios. If we sell now, we may have to pay up heavily to repurchase the funds in the future depending on the bid/offer price mechanism which would be galling, especially if the funds do not gate or else do so for only a relatively short time, as in 2016. We feel uncomfortable of course, but consider this the best course of action though of course we will continue to monitor the situation closely.
  • With regard to the asset class itself, property valuations have rather hit the pause button like so much of ‘real life’ British industry and commerce as we reach the Brexit denouement. Industrials continue to produce the highest returns, especially well-located smaller distribution units benefitting from the e-commerce boom. The Office market remains weak in Central London but strong in the regional markets. Retail remains the weakest of three big property sectors with both capital values and rents falling, no surprise at all given the crisis on UK High Streets which seems to worsen on an almost daily basis. Rental growth for the sector as a whole is forecast to be around 1% over 3 years, led by London and South East Industrials. Weakest sectors remain High Street Retail and Central London Offices, though the latter is showing some improvement.
  • The Commercial Property cycle is long in the tooth, in keeping with the long but shallow economic cycle, but fundamentals remain supportive. Physical supply has been constrained since 2008, as has the supply of credit which typically drives it. Banks have remained cautious since the big crash and leverage still remains relatively benign with LTV’s low, especially in the secondary market. Equity rather than debt financing has played a much larger part in this particular property cycle.
  • Commercial Property still looks relatively fair value. On an absolute, historical basis the 5% IPD UK All Property yield is starting to look pretty expensive but relative to other income producing asset classes, notably bonds, it remains attractive. The sharp fall in long dated Gilts means that spread between the yield on Commercial Property and 10-year UK Gilts is nearly 4.0% which is historically wide with plenty of headroom.
  • The forecast from the boffins at M&G for the IPD return over the next four years has been lowered recently to 3.5% this year and 4.4% per annum over the next five years. With the income return being around 5% this implies no capital growth over the period and in some years a fall in capital values.

Summary: TThe Commercial Property cycle has become increasingly mature and returns will likely be lower going forward, driven almost entirely by rental income rather than capital growth. The concern for Commercial Property ‘bricks and mortar’ funds is the possibility of being gated in the aftermath of a disorderly Brexit

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