Last month’s column (‘Shifting dials’, IC, 24 April) highlighted that the dial is shifting across a range of issues, and how this is contributing to one of the most challenging investment environments for decades. Appropriate portfolio diversification relative to remit and risk profile is now more important than ever. This should include adequate protection from rising inflation. Commercial property assists with diversification, but sentiment is poor. Yet the sector’s fundamentals are somewhat better than generally acknowledged, while it usually does well over time during inflationary periods. As such, wide discounts and high yields once again present an attractive opportunity for the patient investor.
The sector was hit particularly hard by the financial crisis of 2008-09. This exposed those companies with significant borrowings, interest costs and development exposure. The market was ruthless and almost indiscriminate, and significant share price falls were seen. In the years that followed, companies put their house in order to the point that most are more resilient today.
Debt levels are low and the debt that does exist has been secured very cheaply in recent years – with very few companies having any medium-term refinancing requirements. A noticeable feature of this property cycle has been the lack of investment and therefore shortage of supply. Meanwhile, courtesy of the crisis, managers have been far more cautious – there is a lack of development exposure, a focus on income, which has ensured dividends are generally covered, and diversification across sectors and regions. Good asset and financial management have assisted the cause.
As such, the sector weathered the storm of the mistaken rush to the door and closure of a number of commercial property open-ended funds immediately after the Brexit referendum result – which remains a point of discussion for investors and focus for the Financial Conduct Authority (FCA). However, the pandemic proved more challenging. Businesses and tenants struggled, rent collection rates fell, dividends were cut and discounts widened. Sentiment has only partially recovered and this has not been helped by economic uncertainty and expectations regarding rising interest rates.
The investment case
The sector is not homogenous. Real estate investment trusts (Reits) tend to focus on income while development companies look more to capital appreciation. There are also a variety of sub-sectors. It is an asset class with different characteristics to others, such as bonds, renewable, infrastructure or commodities. But it does share a common trait with some in that portfolio returns respond to inflation over time – although over the short term, the relationship is less directly correlated and therefore linear in comparison to infrastructure and renewable energy companies.
Recent research suggests that total returns for the UK sector beat inflation during the period from the end of WW2 to the financial crisis. The composition of those returns changed with inflation. For the first 20 years or so of low inflation and the 1981-2009 period of declining inflation, rental income provided the majority of those returns. However, capital growth assumed greater importance during the period 1967-81 when inflation was an issue. Looking forward, there is nothing to suggest it will be different this time – capital growth should again be in the ascendency in helping total returns exceed inflation over time.
A further concern for some sector sceptics has been worries about the impact of Brexit. This again is proving to be unfounded. Although economic uncertainty abounds globally, evidence suggests investment is influenced by comparative advantage. Our low corporation tax rates, good labour market flexibility, skilled workforce, financial expertise and world-class universities are some of the factors that remain, in aggregate, of key importance in generating growth. Witness the UK’s low level of unemployment and good levels of investment when compared with our EU neighbours – indeed, there have been years since Brexit when inward investment has been more than Germany and France combined.
There are also wider long-term tailwinds for the Reits. The debacle of major open-ended funds having to close their books to redemptions because of their scale following the EU referendum has brought into question whether their structure is best suited for such investments, given the timescales involved. Furthermore, around £20bn was trapped in these funds when redemptions were again suspended at the start of the pandemic in March 2020. The Association of Investment Companies (AIC) and Alan Brierley at Investec, among others, have long been critical of their suitability. The FCA is looking at possible solutions, including the proposal of a 180-day waiting period before redemptions are met.
The closed-end structure of investment trusts is much better suited for such long-term investments. It allows fund managers to invest without having to be concerned about retaining high cash levels for possible short-term redemptions. It also allows gearing, which has increased returns including income in rising markets. Little wonder that, over the long term, the investment trust sector has delivered far superior total returns, while providing investors with a much higher dividend yield.
Looking forward, the prudent use of gearing will again be needed to enhance total returns – particularly if the more cautious estimates of future returns prove correct. Meanwhile, high cash levels within open-ended funds will again prove to be a drag on performance, especially when fees are charged on such balances. For some investment houses, the writing is on the wall. Janus Henderson recently sold its entire £1bn UK Property open-ended fund to an undisclosed buyer – the fund having halved in size following redemptions when suspensions were lifted. Others will probably follow suit. In comparison, Reits will look increasingly appealing over time – the stronger fundamentals being enhanced by current discounts.
Of course, stock and sector selection, together with location, will remain key determinants of the extent of future returns. Recent figures to March suggest year-on-year rental growth approached 4 per cent – the biggest increase since 2016. But the figures mask wide variations – office rents grew by an annual 1.1 per cent, industrial rents by 11 per cent courtesy of continuing strong demand for logistics and storage, and retail recorded its first modest month-on-month increase in four years. Overall, year-on-year capital values increased by 18.2 per cent, and this helped total returns exceed 24 per cent.
Similar returns were achieved in the summer of 2010, which in turn were the highest since 1994. The sector is steadily finding its feet after the pandemic – as evidenced by the investment in UK commercial property in March being the highest for a few years. Other anecdotal evidence suggests demand remains robust. Details of the sale price of the Janus Henderson portfolio were withheld, but it is known to have been above the most recent valuation.
The portfolios continue to favour those companies that focus on industrial assets, given the logistic backdrop and consumer trends assisted by advances in technology. We also favour well-positioned office assets despite the prospect of added flexibility in work practices. This is in part because yields of 7-8 per cent are attractive and sentiment is rock bottom, despite good selection being underpinned by record employment and often by the more attractive alternative uses to which offices can be put, especially housing and/or industrial units. Prospects look particularly attractive outside the south-east. Otherwise, some well-chosen retail assets now look more interesting given a lot of the bad news is in the price.
The favoured holding in most of the 10 real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk is Standard Life Property Income Trust (SLI), courtesy of its well-managed and diversified exposure to the UK market, together with excellent track record of outperformance. Around 80 per cent of exposure is committed to industrial and office assets, with retail and other commercial making up the balance. Despite its cautious approach and the more favourable outlook generally, the company stands on an uncharitable discount of 24 per cent at time of writing, while offering a yield close to 5 per cent.
The portfolios’ other holdings include Regional Reit (RGL), which focuses on good quality and well-positioned offices mostly outside the south-east, where supply is tight. The company has a sound track record under its experienced management, is poised for recovery and is seeing director buying. Yet it stands on a near-15 per cent discount while offering a yield of 7.7 per cent. Again, this is uncharitable. Patient investors will be rewarded.
Another holding is TR Property (TRY), which invests in property shares mostly on the continent, where sentiment is also poor, while holding a modicum of physical property in the UK. As such, its net asset value tends to be more correlated to stock markets than the Reits. It currently stands on a small discount while offering a near-3.5 per cent yield. Like SLI, the company’s track record is very good under its long-established and respected manager and team.
|1 Jan 2009 – 30 Apr 2022|
|YTD (to 30 Apr)|
|*The MSCI PIMFA Growth and Income benchmarks are cited (total return)|