Investment Strategy:  Third Quarter – Commercial Property

  • Property valuations have hit the pause button like so much of ‘real life’ British industry and commerce as Brexit stretches excruciatingly onwards. Rental values are in aggregate flat and capital values are seeing a small fall. The greatest area of weakness, as we have discussed ad infinitum, is Retail with Offices perhaps surprisingly the sector holding up best rather than Industrials which have produce the best returns over the last two years. 
  • Commercial Property brings welcome diversification and through the daily dealt open-ended ‘bricks and mortar funds’ has produced steady and consistent returns to investment portfolios over the last decade with virtually no volatility and little correlation to equity markets.  There was of course a blip, and a pretty big one at that when these funds were ‘gated’ (dealing suspended) for several months following the Brexit referendum in 2016. 
  • We have thus been in a quandary for several months now, loving the consistent, low correlation, low volatility returns (and which significantly  benefitted portfolios in 2018) but hating the risk that investors will panic out of the sector in the event of a disorderly Brexit, which could lead to the funds being gated again. Until recently the lovers had the upper hand and we have continued to maintain weightings in the sector with the attributes and returns offsetting the illiquidity risk. However, with property values now falling in some cases and the prices of the ‘bricks and mortar’ funds completely stalling, the major attraction of holding these funds is fading away. Whilst we want to maintain some exposure to the sector, we reduced the weighting in the sector considerably last quarter.
  • A possible alternative to the ‘bricks and mortar’ funds are closed ended REITs (real estate investment trusts) which themselves invest in the underlying properties, a structure which now encompasses the huge UK property companies such as British Land and Hammerson. Investors frequently buy a fund which itself invests in a basket of REITs, often global ones, to provide diversification. The issue for REITs is that being daily traded investment trusts they can be volatile and have a far higher correlation to the equity market. Being closed rather than open-ended offers the promise of liquidity, though this can be somewhat illusory with liquidity shrinking and prices falling sharply if the underlying asset class is facing problems, as in 2016. Thus, we are not ‘anti-REITs’ by any means, we just see them as a relatively high risk/reward way to invest in commercial property and therefore not suitable for all investors. They are the hare to the ‘B&M’ tortoise. 
  • 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. 
  • On an absolute, historical basis the 5% IPD UK All Property yield is starting to  look expensive but Commercial Property still looks fair value relative to other income producing assets classes, notably bonds. The sharp fall in long dated Gilts means that spread between the yield on Commercial Property and 10-year UK Gilts is 4.0% which is  historically wide. 
  • M&G are forecasting low single-digit returns for the IPD UK All Properties Index 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: The 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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