- Property valuations are in the doldrums as the economy slows and Brexit stretches excruciatingly onwards. Year to date CBRE figures show that up until the end of August Commercial Property has returned 1.9% in 2019. In aggregate, rental values are flat and capital values are seeing a small fall but by sector there is considerable disparity. Industrials and Offices are still seeing small monthly gains in both capital and rental values but these are being more than offset by the dire state of the Retail market where values continue to fall.
- Commercial Property is a very useful diversifier on client portfolios and the daily dealt open-ended ‘bricks and mortar funds’ have produced steady and consistent returns to investment portfolios over the last decade with virtually no volatility and little correlation to equity markets. However, the ‘gating’ in 2016 was a shot across investors bows and returns have turned negative this year. Our concerns have increased that a disorderly Brexit could lead to the funds being gated again and with the prices of the ‘bricks and mortar’ funds now starting to fall the attraction of these funds is fading away. Whilst we want to maintain some exposure to the sector, we reduced the weighting in the sector considerably earlier in the year.
- An alternative to the ‘bricks and mortar’ funds are closed ended REITs (real estate investment trusts). 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 ‘ant-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.
- A couple of quarters ago we discussed the ‘WeWork’ phenomenon and indeed there is an achingly cool WeWork ‘shared work space environment’ just around the corner from us in Hatton Garden. I gaze in envy through the enormous windows at the ergonomic furniture, Pilates mats, cutting edge tech and rather dashing barista. Just when it looked like it was ready to take over the world with its long term debt/short term lease business model it has all gone a bit Pete Tong. Investors at the IPO stage reckoned the company wasn’t worth US$65bn after all, more like US$15bn, and the deal has been pulled for now. The Emperor’s new clothes and all that, when you strip away all the free pomegranate juice maybe it’s just a reckless, badly managed and loss making property company after all.
- The Commercial Property cycle is long in the tooth, in keeping with the long but shallow economic cycle, but fundamentals remain relatively supportive were it not for the all-encompassing shadow of Brexit. 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 fairly expensive but Commercial Property still looks good 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 over 4.0% which is wide by historic standards.
- 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.