Is commercial property worth reconsidering?

It’s understandable why people are pessimistic about commercial property, but a selective approach could prosper over the longer term.

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  1. Rob Morgan

Commercial property funds have, to date, never featured on the Foundation Fundlist, our list of preferred funds for new investment across the major sectors. That’s largely because we often felt the range of options were unappealing. The suspensions in dealing of property funds during the 2008 global financial crisis, again in the aftermath of the Brexit referendum, and more recently amid the onset of the Covid-19 pandemic have illustrated that hard-to-trade assets like physical property have no place in open ended investments, especially where dealing is expected to take place daily.

The alternative, investment trusts, provide a better route to the asset class as they represent a fixed pool of assets. Managers are not forced to buy and sell property, and incur the fees involved, according to the ebb and flow of investor demand. Yet over much of the past decade they have seemed fully priced, with shares often trading at premiums to the value of their net assets.

In part this was due to the very lean yields available on all income related assets at a time of falling government bond yields and a relentless pursuit of income from yield-hungry investors. The occasions when investment trust shares have offered value – such as in the summer of 2016 when the Brexit referendum result jolted markets – have been fleeting.

Covid impact

More recently, Covid-19 has had a dramatic effect on the property market, and certain parts such as high street retail have been plunged into into near-chaotic conditions. Even with lockdowns now eased, greater home working has significantly reduced footfall in many towns and cities that would normally serve legions of office workers. As a result, many tenants are struggling, and some are in dire straits. For the last two quarters there has been widespread interruptions in the payment of rents.

Property as an asset class used to have the advantage that tenants accepted their legal obligation to pay their rent, even when trading was very poor. In the UK, the system has been based around upwards only regular rent reviews, offering considerable income stability for property owners. However, to some extent Covid-19 has upended these supposed ground rules. There is now widespread engagement between landlord and tenant over current and future rental levels given the change in circumstances.

Outside the retail sector, some office tenants are also now asking themselves how much space they will need going forward, and whether they might wish to downsize, relocate or diversify into smaller units. It’s likely that some repurposing of properties will also need to take place, especially in marginal shopping space. Both rent and capital values are in a state of flux as these trends play out.

How funds have fared

Suspensions of open-ended funds continue on the basis there still have not been enough transactions to evidence accurate valuations. Some valuers are now saying they can value certain types of property more realistically, such as industrials, but for a mixed portfolio there’s still not enough data to go on. We expect these suspensions to continue for a few more months at least. In the meantime, investors must take the unit valuations with a pinch of salt, but in many cases they can continue to receive a reasonable, though generally lower, level of income.

Meanwhile, the share prices of investment trusts show a mixed picture. Certain specialist trusts that target what have turned out to be resilient areas of the market (such as warehouses, supermarkets or healthcare) have performed well, whereas the more generalist trusts remain depressed, especially those with heavy exposure to retail and, to a lesser extent, offices. Some have cut, cancelled or postponed their dividend payments due to falls in rental income.

According to BMO Asset Management, the worst performing European property share subsectors during the ‘Covid trough’ (19th February to 20th March 2020) were hotels (-58%) and UK retail (-52%). Interestingly, hotels have recovered more strongly but both areas have missed out on the recovery bounce compared with industrials, self-storage, healthcare and residential, which are now only a little lower than their pre-pandemic levels.

It’s not all bad news

It’s understandable why people are pessimistic about future rental and capital value trends for commercial property. The large falls, and in some cases rapid recoveries, in investment trusts and property companies reflect the way the stock market tends to exaggerate trends. Some companies also have some borrowing, which damages results when rental income falls.

We do think it pays to be mindful of the areas challenged by structural trends such as the move to online shopping and greater use of flexible working. Yet we could now be at a juncture where there are some areas of value for both income seekers and bargain hunters able to withstand volatility and commit for the longer term. It’s a time when an experienced and insightful property investment manager could add greater value than normal through a selective approach that considers the bifurcation of many property subsectors.

The office market is a case in point. The transition of office workers to working from home has been remarkably smooth in many cases and it raises many questions on future demand for office space. Working from home has clearly proved popular, and for many office-based businesses there is likely to be a balance in working patterns between office and home, as well as more flexible use of spaces in future. Yet few businesses are likely to abandon the office altogether as collaboration and creativity flourish in teams that work in close physical proximity at least some of the time.

Over time the UK and more of Europe could migrate to the model pioneered in Scandinavia. In Sweden, a third of the workforce occasionally working from home with companies and workers embracing flexible working in modern ‘green’ offices with low carbon emissions, outdoor space, natural airflows and good facilities. Companies are increasingly willing to pay up for these high-quality properties to attract employees, but their popularity means they are in short supply. The office merely evolved rather than died, and by meeting tenant preferences it was possible to achieve strong rental growth.

Across various property subsectors, not just offices, we are likely to see is a redefining of what constitutes a ‘prime’ property. This was probably always going to happen but, as with many things, Covid-19 has acted as an accelerant of the trend and a disruptor of the natural order. The property market is incredibly varied and while a net reduction in floor space requirements seems inevitable, it will likely have a bigger impact on ‘secondary’ buildings with high employee density as smaller, flexible and high-quality spaces are increasingly sought after.

One option in the sector

The key to successful property investment at the present time is twofold. Firstly, diversification. UK property funds are diversified across various property types: retail, office, industrial and so on. However, the more diversification the better. The ability to harness resilient income from multiple sources both conventional and specialist – such as German residential, healthcare, long lease logistics, supermarkets and self-storage assets – can create a more reliable overall income stream.

Secondly, flexibility. Being able to target the areas where rental income growth is robust and having the agility to move in and out of subsectors according to how valuations move could be an important advantage. The market is likely to be more heterogenous and fast moving than ever so a nimble go-anywhere fund could have an edge.

One option favoured by our Collectives Research Team is TR Property, an investment trust that holds a portfolio of real estate investment trusts and property companies across Europe. In addition, it has a small level of direct UK property exposure (presently 8%). The investment selection process seeks to identify well-managed companies of all sizes with the manager, Marcus Phayre-Mudge generally regarding future growth in income and capital appreciation potential more highly than immediate initial yield or discount to asset value.

Within the portfolio there are limitations on the size of individual investments held to ensure diversification. UK listed equities represent 25–50% of assets, Continental European-listed equities 45–75% and direct property UK 0–20%. Up to 5% each can be invested into other listed equities, listed bonds and unquoted investments.

The Trust has not been immune to this year’s events, but from an income perspective it is robustly positioned as the manager has continued to prove himself adept at staying away from the most troubled areas. We regard the Trust as an offering a high quality, diverse exposure to the asset class, though it should be noted that it may employ levels of gearing (borrowing to invest) subject to an overall maximum of 25% of the portfolio value and this increases risk  – presently the level is 17%.

The Trust’s stated yield at present is 4.1% (variable, not guaranteed) and is based on previous dividends. It is possible that the Trust’s underlying income generation will not support this level in the shorter term as portfolio holdings reduce pay-outs. However, the manager does report high rates of rent collection from healthcare, logistics and residential; all sectors well represented in the portfolio. In addition, the Trust has a healthy level of revenue reserves. These have been accumulated over time and can be used to supplement short to medium term falls in earnings until conditions settle and the long-term income capability of the portfolio can be better determined. Shares presently trade at a discount of 13% to net asset value.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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