Commercial property making a comeback

The case for commercial property

There is no shortage of media commentary about the buoyant housing market. Whether built on sand or not, the market is booming. Figures suggest the average price has now surpassed the previous peak in 2008. And yet, six years on from the start of the commercial property downturn, many believe the outlook still looks bleak for the sector - particularly outside the south-east.

Sentiment is depressed. Outside London, prices remain around 40 per cent below their 2007 peaks. This capital loss cannot be said of many other asset classes today - the FTSE All-Share having retaken its pre-crisis high.

As a result, yields are appealing. According to recent figures from the Investment Property Databank (IPD) the sector offers a gross yield of just over 6 per cent. This is very attractive in this low interest environment - certainly when compared with gilts. Furthermore, all things being equal over the longer term, there should be scope for modest income growth as rental increases reflect a slowly improving economy.

Indeed, leases are usually worked out on an upwards-only basis every five years or so. At worse, rents stay the same or are increased to market level. This aspect of the asset class is particularly attractive to institutional investors when comparing yields with bonds. But it is also becoming increasingly attractive to some of the private banks, which are buying properties on behalf of their clients. Other private investors are also taking note, with auction houses reporting a growing increase in demand. London has been the focus to date, but this too may be changing.

This level of yield has certainly been a factor as to why investors are tentatively returning to commercial property. But there has been another. Just as an improving economy should be supportive of rental increases, so it should help capital values.

We should not get carried away - the extent of the debt overhang will mean that economic growth will remain anaemic. However, the new governor of the Bank of England has recently confirmed what many of us have suspected for years, and that is interest rates are set to remain low for the foreseeable future. Forward guidance suggesting that the bank is targeting a 7 per cent unemployment rate is quite a departure from his predecessors.

This, together with various other initiatives to encourage bank lending, confirms economic growth has assumed a greater emphasis relative to inflation.

And the GDP figures have been ticking up of late. This improved economic outlook has begun to filter through to the sector. One signal of this is that rental growth outside London is now beginning to occur. Add in the fact that there is less of an overhang of vacant properties this time around, and the fact that finance is becoming more readily available for private investors, and we have the makings of a commercial property revival.

In fact, I would go further. Given the yield on offer with some sub-sectors such as good-quality industrial offering around 8 per cent outside the south-east, and the prevailing outlook for interest rates and bond prices, I believe we could be in the foothills of a very marked upswing in commercial property values - and investors want to be positioned accordingly.

Portfolio changes

I have added to existing holdings of TR Property Trust (TRY) in both portfolios. TRY invests mostly in property shares on a pan-European basis and has a 60:40 large-small cap weighting. The benefit of its continental exposure is that rents rise with indexation, and not the five-yearly reviews as in the UK. This is attractive given that government policies will result in a pick-up in inflation in order to help erode debt levels. Furthermore, sentiment on the continent remains depressed relative to the outlook - and valuations reflect this. A prospective yield of 3.7 per cent - with revenue reserves exceeding one year - all add to the attraction.

I have also added again to the existing holding of Standard Life Property Income Trust (SLI) in the Income portfolio because of its high and good-quality yield. Despite its run since I last topped up, its 4.53p dividend still means it offers a 7 per cent yield - bolstered by revenue reserves of around one and a half years.

To help fund these purchases, I have reduced existing holdings of Worldwide Healthcare Trust (WWH) in both portfolios. Regular readers will know that I am very positive about the healthcare and biotechnology sectors. But WWH has had a phenomenal run and the discount has closed up considerably - time to top-slice. I still retain holdings in both portfolios, while the Growth portfolio retains its biotechnology trusts.

A number of other changes were made during August. I continue to steer both portfolios towards the UK's improving outlook. I have added to existing holdings in JPMorgan Mid Cap Trust (JMF). As the economy gradually picks up, the middle capitalisation stocks (and smaller) should continue to do well relative to their larger brethren. A 12 per cent discount and 2.6 per cent yield is reasonable value.

Within the Income portfolio, I have sold the final tranche of Scottish Oriental Smaller Companies trust (SST) - readers will remember that in July I sold entirely the Growth portfolio's holding and reduced the Income portfolio's weighting. The logic remains as described in last month's column. The proceeds have helped top-up the existing holding of Invesco Leveraged High Yield Trust (ILH) with its 7.7 per cent yield - it is important not to forget the important discipline of rebalancing.

Finally, within the Growth portfolio, I have added to existing holdings of City Natural Resources Trust (CYN) and Utilico Emerging Markets Trust (UEM) while at discounts of around 17 per cent and 10 per cent respectively.

I have also introduced a new holding of JPMorgan Smaller Companies trust (JMI), which presently stands on an 18 per cent discount. Sentiment trails fundamentals in all three sectors - more in forthcoming columns.

View John Baron's updated Investment Trust Portfolio.