U.K. Commercial Property: A Glaring Opportunity Or A Brexit Disaster?
Opportunities to generate income on investments are vanishingly rare, which is why the recent Brexit-related-wobbles in the U.K. commercial property sector have been worrying for investors. Diversification of income is tough enough, without being forces to abandon an entire sector. However, there are signs that asset allocators are dipping a toe back in this unloved area.
John Redwood, chief global strategist for Charles Stanley, wrote in the Financial Times that anti-Brexit sentiment had weighed excessively on the sector and fears of declining rents and weakening property values had been overblown. He said: “At the very time U.K. listed Reits are cautious and their property valuers are fearful, overseas buyers are piling into London like there is no tomorrow. City skyscrapers have sold for sky-high amounts. In March a Chinese property developer paid £1.15 billion for the Cheesegrater — a yield of just 3.45%. This price was 26% more than its recent September valuation.”
It is not the only landmark building to be snapped up by foreign investors, encouraged by the significant decline in sterling - the Walkie-Talkie was sold to a Hong Kong investor for £1.3bn. The deal for the Nine Elms development in Vauxhall has been revived with new Chinese buyers.
Redwood has been a prominent Eurosceptic and, as such, is more naturally optimistic about a post-Brexit future than many, but he is not alone in supporting commercial property. Whitechurch Securities investment director Gavin Haynes has been adding to the asset class having exited last summer due to concerns over valuations. He says: “On the effect of the Brexit vote and the effect of investment flows on liquidity, we are now more sanguine. The yields offered by the asset class appear attractive relative to bonds, while the U.K. economy has not fallen off a cliff and overseas buyers continue to support demand. As a result we have added a modest weighting to cautious and balanced mandates.
“This recent move back into property is endemic of our view that with cash continuing to provide a negative real return, there are opportunities across asset classes that can provide more attractive long-term growth prospects and more attractive yields.”
Certainly, valuations have come down. For many property investment trusts there is a marked difference between their recent NAV performance (i.e the value of the properties they hold) and their share price performance. The Standard Life Investments Property Income trust, for example, is up 44.2% in NAV terms, and just 36.5% in share prices terms over three years. F&C Commercial Property is up 38.9% in NAV terms, and 34.2% in share price terms over the same period.
The yields are undeniably attractive. The highest yielding investment trust – the AEW UK REIT – has an historic yield of 7.8%. Even the lowest fund in the sector – the Schroder Real Estate Investment trust – has a yield of 3.3%. If investors are worried about capital values, the income provides a nice cushion.
However, a note of caution. Those inside the industry are still concerned about certain areas of the market. Alex Short, portfolio manager, AEW UK REIT, said in the group’s recent results statement: “Industrials, distribution and alternative assets may all provide investment opportunities but are very expensive and we remain cautious about Central London offices until the Brexit negotiations are further advanced. The structural problems affecting much of the town centre regional retail market seem likely to persist.”
He says the group is starting to see an increased number of attractive opportunities in the retail and office sectors and expects future acquisitions will represent a more balanced spread of property sectors, rather than being concentrated in the industrial sector.
He concluded: “Assuming that the economy performs in line with consensus forecasts, and there are no major shocks, we are looking towards a period of positive total returns, supported by the income return.” Herein lies the problem – is it possible to say that the U.K. economy will not face any shocks? Certainly, there appears to be a move towards a softer Brexit, helped by a recent shift in Labour’s position on exiting the EU. However, the outcome of the Brexit negotiations is still far from certain and there may be trouble ahead for the U.K. economy.
Richard Kirby, manager on the £1.3bn F&C Commercial Property Trust, echoes Short’s caution. He says political risk – particularly uncertainty over Brexit - and the disruptive impact of technology mean that better management of existing assets is likely to account for more of the trust’s returns. He adds that property values in London remain high.
A word on the perennial debate between investment trusts and unit trusts for U.K. commercial property: Yields are higher for many investment trusts and the structure offers a better way to manage the inherent liquidity problems of commercial property. Open-ended funds that invest in direct property often see a "cash drag" as they are forced to hold high cash levels to meet potential redemptions. Expert investors, such as Hargreaves Lansdown’s research director Mark Dampier, have long argued that open-ended funds are not an ideal structure for commercial property and, at this juncture, investment trusts appear to hold better value.
There are no great riches to be made here, but the same could be said of most asset classes at the moment. The question is whether the higher income is worth the inherent risks. On balance, commercial property probably still merits part of a balanced portfolio, particularly when the diversification benefits are taken into account.